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A tax formula to beat inflation
November, 17th 2012

The Reserve Bank of India is so obsessed with inflation that it has kept money tight for a long, long time. It does not seem to be bothered that its efforts have not been successful. It could argue, and so it will, that if it had not kept money as tight as it has, inflation would have been worse. That is like the socialist argument that the economy would have been worse but for socialism.

Actually, as The Hindu (November 15) has remarked, the policy has inflicted on the Indian economy a triple whammy the weak monthly industrial data for September, still high retail inflation for October and the latest poor external trade figures. Though inflation has indeed come down to 7.47 per cent that still is a very high figure.

Regulating inflation is basically a control problem. Therefore, it is rather surprising that economists have not looked into the way engineers operate control systems.

If the RBI Governor D. Subbarao had studied engineering and not physics in the IITs, he would have known that engineers often use a three-term control system the first to control the function, the second to control the integral of the function and the third to control the differential of the function. In economics, that would have been taxing incomes, wealth and change in incomes.

For some reason or other, economists are interested only in taxing incomes and wealth and not changes in income. That is a pity because inflation is directly related to increases in (money) incomes. Theoretically, if changes in incomes are taxed, inflation should tend to become zero.

Unfortunately, economists have important reasons to make exceptions and give concessions. Hence, taxing increases in incomes only partially may not reduce inflation to zero, but yet will be preferable to tight money.
Three taxes

Therefore, I suggest three kinds of taxes: income tax, wealth tax and taxes on increases in annual income. Ideally, wealth tax is supposed to reduce wealth to zero.

It has done that largely in the case of British nobility. In a dynamic economy, wealth has always been generated (and lost).

Often, wealthy people find ingenious ways of not paying taxes. Hence, though ardent socialists disagree, we may even drop wealth taxes and replace them by taxes on changes, rather increases only, in incomes.

It is well known that increases in incomes tend to cause inflation for short terms only unless the increases take place continually.

Unfortunately, that happens often inflation increases demand for higher income and that increase in incomes pushes up inflation further. Actually, it all depends on how the increased income is used. If it is used to buy things that are readily available, little or no inflation will result. On the other hand, if the increase in income is spent on articles in short supply, that will definitely cause inflation.

Therefore, if every person whose income has increased does not spend it but holds it till the good he wants is readily available, there will be no inflation. He may do better and give the amount as an advance to the producer to increase production.

Unfortunately, such restraint is rare; it is also virtually impossible to enforce, because nobody knows which goods output should be increased to raise the production of any product.

Certainly, a mere increase in producing the item demanded will not do; we may have to increase the production of electricity, raw materials, roads, education and healthcare. Sorry! We cannot ask everybody whose income has increased to pay for the increase in production of all the required items needed to increase production of the particular item desired.
Gold-backed bond

Let us make it simpler. Let the Government treat the tax as a sort of short-term loan. How short or long that term should be can arouse much debate. It could be one year or even 10 years. Possibly, three years is the maximum that people will tolerate. Then, the increase in income is not exactly taxed outright, but returned sometime later. Unfortunately, even the amount to be returned will cause much debate or even distress particularly in an inflationary economy.

We could ameliorate that distress somewhat by indexing the loan, say, to the price of gold. Then, the system may operate as follows. One, a temporary deduction is imposed on taxpayers on the increase in annual incomes.

The taxpayer may deposit the amount deducted in a bank in a gold-price-indexed bond. (No gold is purchased, and hence, the transaction should not affect the price of gold.) The taxpayer may be given a further sweetener of a small interest of around 2 per cent or so. The bank credits the total amount of principal plus interest to the taxpayers account at the end of the due term.

In effect, the Government gets a low interest loan for a short term. Where could the Government invest this? Usually, the Union Government will collect the tax and spend it the way it likes.

That gives a bonanza to ministers, and they would not like to surrender it. Let us hope, against hope, that we will get a selfless minister, and he will let the amount to be competed for by a State or a district or a tehsil or even by a panchayat.

Then, the lower government agency offers inflation-indexed loans for a short term on various projects; the taxpayer gets a choice about whom to patronise.

Let us remember that everyone grumbles about paying taxes, but gladly contributes happily to an institution of their choice.

(This is 342nd in the Vision 2020 series. The previous article appeared on November 3.)

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