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Should income tax be abolished: Analysis
January, 08th 2014

At the heart of any question about tax - whether on incomes or non-income - is one of ideology and social philosophy, not just economics. If you believe in the idea of free markets and a minimal state, the question on whether you should abolish income tax or merely make its collection more efficient depends on the outcomes you expect from it.

If you believe in a limited role for the state, where it performs some essential functions that no one else can, and stays away from becoming a major economic player itself, then it is logical to move towards a situation where taxes keep falling as national income and prosperity grows.

The logic: as the size of the economy grows, economies of scale will bring down the relative costs of several components of state expenditure. For example, you don't need to double the army or the bureaucracy just because GDP has doubled. Nor do you have to double the volume of currency printing: it’s not only because of the ongoing shift to non-physical electronic transactions, but because a minimalist state will allow private currencies to also play a role in providing competing modes of transaction settlement, improving economic efficiency.

If Bitcoin, gold, Litecoin and other private currencies coexist with the rupee or the dollar, the most efficient unit of currency will gain dominance over time. It will also make the state more accountable and aware of the costs it is incurring in offering a service. If tomorrow gold or a privately printed rupee is more valuable than the official rupee, all the government needs to do is to ensure the new currency’s printers live up to their promises. It can then gracefully exit the currency business itself.

In a minimalist scenario, the job of the state would be to defend its territory, enforce the law and contracts between private parties, regulate the macro-economy, and provide basic public goods and services that benefit all (law and order, clean streets). It can leave the provision of public goods (freebies, food security) to others. The state should not try to be a player in the provision of commercial goods and services, or general do-gooding. Its job is to facilitate these processes so that the job gets done - including feeding the poor or running free schools or universal healthcare.

The general principle on which a minimal state should function is this: if somebody else can get the job done, it should not do so itself. If no one is willing to do a job, it must incentivise the same through tax or other policies. Only if no one is willing to do an essential job for love or money should the state directly enter the picture and provide a good or service.

In a minimalist state, taxes should go down as a proportion of GDP, not up. Economists in general keep arguing about the tax-GDP ratio and how it can or must be raised, but the question that needs posing is the opposite: how can it be brought down so that there is maximum freedom for citizens to live out their lives and their dreams, and grapple with their failures.

So when P Chidambaram tells us in his 2013-14 budget speech that “we must reclaim” the recent tax-GDP ratio peak of 11.9 percent (it is currently below 10 percent due to the slowdown), we have to ask him why: why must the ratio always go up? Raising the ratio is not an end in itself; it is the result of economic growth, and rational economic theory should tell us that as an economy grows, if the ratio rises, it means the state should start cutting taxes and let citizens benefit from it. When the size of your business grows, your overheads must come down not go up. It should be the same with economic growth.
Actually, we should not bother about the tax-GDP ratio at all - it may go up or down depending on economic conditions. What we should bother about is what taxes do to growth - and whether having more taxes is a help or hindrance to growth. It is best to look at taxes as an overhead: as you grow, the overhead per unit of output must come down.

This is the fundamental ideological position from which I have suggested the abolition of income tax (on non-corporations) in an article yesterday. This is a companion piece for underlining the premises on which the article is based. I am shortly amending the article itself based on feedback and some inconsistencies.

Economists love income tax because it is a mother lode of easy money - especially when it is deducted at source from organised sector salary earners. Left wingers love this tax because it panders to their vicarious need to soak someone (especially those they consider the rich) using someone else need as the excuse (the poor, etc). Robinhood is often the most sought after role in society.

Looking at taxes purely from the point of view of human psychology, income tax is the one tax no one would like to pay if they can find a way to avoid it - legally if possible, illegally, if not. This is why people love deductions and tax loopholes. The reason is because we see income as ours by right – payment received for work done. So when someone tries to take a part of it away, it creates dissonance.

On the other hand, we usually don't grudge paying tax when we buy something. Buying something is a voluntary, and often discretionary, act, and so we are not coerced into paying a tax related to it.

This is the logic behind deciding whether to cut income or non-income (good and services) taxes. If you want to reduce the ambit of the state, you should be cutting income tax first and then other taxes. The long term goal is to bring down taxation as a percentage of GDP to expand the freedoms of the individual by making the state a mere catalyst and not a central player in our lives.

Behind this idea is another ideological and philosophical premise: the economic relationship between state and citizen. A state exists only because of the give and take relationship that exists between them, which includes a customer-service provider relationship. An emotional connect may or may not exist between citizen and state, but that has to be in addition to the contractual one.

State and citizens trade economic and other benefits between them. Just as you pay a price for buying a Hindustan Unilever product or for the services of a management or tax consultant, the state has to provide equivalent service for price paid (i.e. taxes collected).
If the Indian state collects Rs 10-12 lakh crore in taxes every year, the centre has to tell me what service it is providing me for this cost - and what the alternatives are. We all need to know what it costs to provide for the country's defence, protecting citizens (police, courts, etc), providing basic facilities to the poor, etc. If the cost of providing a state service is greater than providing it privately, then we have to start looking at the alternatives.

More important, we also need to know if the taxes collected are resulting in increased economic efficiency or less. The truth is large parts of the Indian state are about creating work for itself and making the lives of citizens harder.

Take a simple thing like know your customer (KYC) norms. The idea is to ensure that any service provider knows his customer to be a genuine citizen, and not a terrorist or crook who is to be denied the service. But the whole KYC rigmarole has become so counterproductive that it is an impediment to business and inconveniencing citizens. The system of centrally prescribing a set of inflexible rules for every bank or mutual fund has become an expensive indulgence where crooks simply fake the papers and millions of ordinary citizens run around from pillar to post to generate the papers needed. The KYC is essentially a systemic boondoggle, where we spew endless reams of paper and copies, creating work that adds no value to anybody.

The idiocy of KYC was nowhere better demonstrated than in the case of former Reserve Bank Governor Duvvuri Subbarao, who initiated the entire round of KYC complications in the banking system, and recently faced roadblocks to opening his own bank account in Hyderabad post-retirement. He had a tough time being KYC-complaint.

However, there is a reason why such stupidities happen. The purpose of the state is to perpetuate itself, and for doing so it will keep inventing reasons to expand its ambit. If today terrorism provides a reason, tomorrow the poor will. Once you justify the need for expanding the state, you will ensure that your resource needs expand. And once this happens, you will justify more taxes, and so on.

Just as work expands to fill up available time, the state expands to soak up available resources - even if it means creating useless expenditures of the citizen and itself through KYC, or multiple taxation, or whatever. Once KYC becomes an end in itself, to overcome the problems related to KYC the state will offer Aadhaar as the silver bullet to solve the KYC problem. And once Aadhaar proves to be of dubious benefit and seriously compromises citizen privacy and security, the state will invent another scheme to keep itself and citizens busy - and justify even more taxes.

The case for the abolition of income tax on individuals is this: there is no justification to confiscate what is mine till you give me a specific service in lieu of this sacrifice. Put another way, no tax has a justification till it is clearly identified with providing an explicit citizen service - and all taxes that don't have this justification have to go.

If the state says defence needs a 3 percent tax on every citizen, and makes a reasonable case for it, I am happy to pay it. We can all pay a 3 percent defence tax, rich and poor, based on our incomes or expenditures. There is no need to knock off 34 percent from everybody’s incomes in the name of raising the tax-free ratio.

It is a justified need that must result in taxes, and not the need to provide more resources to the state, never mind how it is used.

The onus of proving the need for any tax lies with the state. Not only that, no tax must stay on the statute book forever. Its existence must be periodically justified.

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