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Their capital gains

The Indian taxation system encourages the concentration of wealth in the hands of a few people. This is dangerous. Abhijit Banerjee writes.

india Updated: Aug 04, 2011 23:50 IST
Abhijit Banerjee

Sitting, as I am right now, in India, there is a certain grim pleasure in watching the world's largest economy teeter on the edge of defaulting on its government debt (with, no doubt, drastic consequences for the world economy), all because of the Republican Party's refusal to permit any increases in the income taxes paid by the ultra-rich, people who earn many times what the average American earns.

The extraordinary protectiveness for the interests of the very rich that this reflects is, depending on your point of view, one of the more bizarre or unique aspects of US political life. The US could easily balance its budget by a combination of taxing the super-rich at levels that most other developed countries consider normal, and raising the age at which people become eligible for a public pension, but seems politically unable to do so. By contrast, a lot of southern Europe also has a huge problem with government debt, but for the more conventional reason that they cannot easily raise tax revenues or cut spending enough. This is why countries like Greece, Portugal, Spain and even Italy seem to be headed towards a major crisis (Greece has already made it there, the rest seem uncomfortably close.)

We in India also have large and intransigent budget deficit and we have governments both in the states and at the Centre that seem to have no interest in reining back expenditures. Can we get into a European style crisis any time soon?

The short answer is no, as long as we keep growing. Deficits add to our debt burden, but growth adds to our GDP and this helps to keep the debt to GDP ratio more or less within control. Equally importantly, growth is in part what is driving inflation, which means that the real value of the existing stock of debt is going down. In a more free-market environment, this would create pressures to raise interest rates on government borrowing, but this has been finessed by basically forcing the banking sector and other large financial institutions to hold Indian government debt at the stipulated interest rates.

This is obviously not a perfect arrangement. In effect the system survives in part because savers in India get paid very low real (i.e. accounting for the inflation that erodes their capital values) interest rates — indeed in the last few years real rates may have been negative. These savers are not the very rich, who have their money invested in the stock market and in their own businesses, and more recently been given limited access to world financial markets and therefore can protect themselves from inflation. They are the middle classes, people who are trying to have enough money when they retire to not need to rely on their children. It is not implausible that these people are actually target savers, and as a result, save more when interest rates go down, in an attempt to keep their post-retirement income more or less fixed. This might actually explain why our savings rates are now shooting through the ceiling. (I am told that a recent analysis based on Centre for Monitoring Indian Economy data shows that a lot of people are saving at rates that would make the Chinese blush.)

In other words, even though we do not have an explicit political commitment to protect the rich, unlike the US Republicans, we do end up letting the middle classes do a lot of the heavy lifting. We prey on the very middle class desire for secured old age, in order that the economy can live above its means.

In part this reflects the inherent constraints on the Indian tax system: our organised sector, which is the one sector that is easy to tax, is smaller than it should be, mostly as a result of a history of labour market and other regulations, and agricultural incomes remain entirely shielded from any taxation. Therefore, the amount of extra revenue that can be extracted by raising the marginal tax rates on income may be limited, especially given the compliance issues. (That is no reason not to try, especially because the yields from the highest brackets will go up as the economy continues to grow.) However I see no reason we could not do more with wealth taxation, for example: financial wealth does not seem to come under wealth taxes and there are also no capital gains taxes on financial assets. We seem to be much too vigilant in promoting wealth accumulation by the wealthy, but not by anyone else.

Apart from just the unfairness of this, this is a system that actively encourages the concentration of wealth in the hands of the few. As if all those forces that already help wealth breed wealth were not enough, we are creating an oligarchy, as it were, by fiscal fiat. It is time to be careful.

Abhijit Banerjee is Ford Foundation International Professor of Economics and Director, Abdul Latif Jameel Poverty Action Lab, MIT. The views expressed by the author are personal.

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