Thomas Piketty's seminal book on inequality, Capital in the Twenty-First Century, comes at a fortuitous time. Although inequality has been a well-discussed issue in India for some time now, the success of the book contributes by sharpening the debate. It complements the McKinsey Global Institute's (MGI) report titled "From poverty to empowerment: India's imperative for jobs, growth, and effective basic services" and a staff discussion note by the International Monetary Fund (IMF) titled "Redistribution, Inequality and Growth". Between them, the three works allow a comprehensive response to a vexed issue including identifying the problem, analysing the shortcomings of our historical responses, understanding the consequences of inaction and initiating the course-correction required to ensure that these consequences are avoided.
The IMF report formalises the relationship between inequality and economic growth, concluding that low inequality is almost certainly an essential component of fast, durable economic growth. In addition, it also tests the fondly held belief that redistribution is necessarily negative for economic growth. It concludes that not only are the direct effects of redistributive efforts benign, the sum of direct and indirect effects is actually supportive to growth, provided certain conditions are satisfied.
An analysis of the literature reviewed in this note suggests that there are a few key determinants of whether redistributive policies hurt or support growth. Broadly, high subsidies and tax rates have an exponential negative impact. As such, they don't hurt much at low levels but the negative impact increases dramatically as they rise. However, there are a few exceptions to this. If subsides are designed such that they enhance the risk-taking ability, health and education levels of the poor, the benefits that arise from these can help offset their negative impact on the labour and capital markets. Also, tax reforms that plug loopholes for the rich (capital gains and inheritance tax) with an offsetting reduction on taxes on labour income are not inherently harmful for economic growth. And finally, if tax revenues support expenditure on subsidies, the negative economic impact is muted.
Piketty's basic premise is that unhindered capitalism necessarily results in extreme inequality and it is up to governments to institute measures to balance it. His study of seven centuries of data across 20 countries reveals that inequality has reduced only in a redistributive welfare state environment. This has intuitive appeal. In its most natural and unbridled form, capitalism necessarily assumes that everything can be bought and sold, even justifying slavery as a commercial pursuit. Consequently, capitalism can only co-exist with civilised society in a neutered form; with restrictions on what can be bought and sold. Apart from protecting life, liberty and property, the primary role of government is to prescribe limits within which capitalism operates. It needs to be noted that the book neither makes a case against meritocracy nor recommends restrictions on individuals' right to retain the fruits of their labour. Instead, it encourages governments to address extreme concentration through progressive and targeted taxes using the proceeds to assist the deprived and destitute.
The MGI report represents the culmination of a massive effort to understand the impact of various government efforts to address poverty, or the extreme end of our unequal income distribution. It finds that economic growth, and the opportunity it creates is three times more effective in tackling poverty than our existing government subsidies. In addition, it finds that despite many people rising from poverty, access to basic facilities such as education, drinking water, hygienic toilets and basic health care remains woefully inadequate.
Apart from helping us understand that low inequality is an economic necessity, these also help us analyse efforts taken by our government towards this end.
On the expenditure side, the most significant subsidies we introduced over the last few years did absolutely nothing to enhance either the risk-taking ability or the education levels of our poor and deprived. In fact, by virtue of being non-merit based, initiatives like the rural employment guarantee scheme actually reduced the risk-taking ability of our rural workers, encouraging them to stay home and receive a guaranteed wage rather than explore the country's labour market. This also imparted a supply shock to our labour market and the economy as a whole with relatively insignificant offsetting benefits. Another non-merit subsidy, the Right to Food initiative together with the minimum support price regime distorts the entire food grain market in India, once again with insignificant offsetting benefits. With two of our largest initiatives imposing huge economic costs and not generating offsetting benefits, our economy was doomed to suffer.
On the revenue side, our perverse tax regime ensures that the rich pay the lowest possible rate of tax by applying the lowest rates of tax to capital income and the highest to labour income. We do not have an inheritance tax, which allows large chunks of wealth to be passed from generations who earned it to generations who were born to it, allowing inequality to acquire inter-generational persistence.
And to complete our folly, our subsidy bill is almost completely financed through deficits.
While it is unimaginable that a country like India, where extreme destitution co-exists with irreconcilable levels of wealth, can survive without redistribution, it is painfully obvious that our chosen policies have been almost exactly wrong. As such, apart from initiating the right policies, it is equally essential to correct the wrong ones.
First, we need to convert all our existing non-merit initiatives to a merit-based format, with the sole aim of eliminating destitution and deprivation. Secondly, we need to use the money saved from this change to increase allocations to socially and economically beneficial sectors such as education, hygiene and health care dramatically. Thirdly, the tax regime has to be corrected to become truly progressive in nature. Over the past few years, nations across the world have corrected their tax regimes to tax capital income fully. We need to do the same. Additional income so raised must be directed towards reducing taxes on labour income to allow a widening of our savings and capital base. Lastly, we need to chart a course to ending budget deficits as quickly as possible.
Our current level of inequality isn't just a danger to the economy; it's a danger to the extremely delicate socio-political contract called democracy. Democracy rests on the cardinal principal that votes cannot be traded. However, just as extreme wealth gives a (s)elected few the ability to buy votes, destitution gives birth to an army of willing sellers. Reducing inequality is no longer just about the desirable.
It's about survival.
The writer is Director & Business Head Portfolio Management Services & Product, Pramerica Asset Managers
These views are personal