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Selective taxation to curb inflation
February, 19th 2007
Inflation will be cured only when the management of the economy is improved by liberalising education, real-estate and agriculture, says P. V. INDIRESAN, suggesting two immediate palliatives a tax on the increase in disposable income over the previous year; and on construction on land whose value exceeds, say, Rs 1,000 a square yard.

It has been said that a week is a long time in politics implying public opinion is fickle. It appears expert opinion is no less fickle. Within a few days of Goldman Sachs declaring that India will become the world's second largest economy, The Economist has warned that Indian economy is in grave danger. Who do we believe? Actually, we should accept both. India can become the world's second largest (or even the largest) world economy but only provided we heed The Economist's warning against increasing inflation. Against inflation, economists have one standard remedy make money more expensive, either by increasing the Bank Rate, by reducing money in circulation or both. Dutifully, the Reserve Bank of India has done both.

Severe side-effects

Unfortunately, that is a medicine with severe side-effects - it stunts growth; increases unemployment. Then, which should we prefer higher inflation or slower growth rate? Some economists prefer the first and others the second. There is no agreement on the issue. Raising the Bank Rate or the Cash Reserve Ratio is like a rise in the flood level of a river: Those who had just managed to keep their heads above water drown; those who dared to test their strength to the limit die. Stronger ones will have some difficulty but will survive. The timid too, who dared not cross the river, will be safe. Similarly, a hike in interest rates hurts the rich a little; the poor will remain as destitute as before but those who dare the most collapse. That is a tragedy; we lose our best entrepreneurs.

In the 19th Century, physicians operated on the theory that illness is caused by accumulation of bad blood. Therefore, whenever someone had high temperature, they bled the patient. The theory we have about inflation, and the cure we prescribe, is no different: Come inflation, we bleed the economy. Instead, we need a selective approach: Target only that which fuels inflation; leave the others alone. Hike in interest rate acts like a sledge-hammer that squashes everything whereas what we need is the delicate touch of the surgeon's scalpel to cut off only the diseased part. The ideal is not holding back every part of the economy but only those that are causing inflation.

Three areas of concern

Currently, in the matter of inflation, there are three areas of concern: Wages in the hi-tech sector, real-estate and agriculture.

India has nearly 2000 engineering colleges; there is no shortage of engineers but there is an acute shortage of employable engineers. That is, quantity is not the problem; quality is. Or, the root cause of wage inflation is poor quality of education and training. Therefore, the culprit is poor management of education. As for real-estate, to build 10 million houses a year, we will need no more than 0.1 per cent of the land area. Once again, as in the case of manpower, availability is not the issue; poor resource management is.

In the case of agriculture, if productivity rises to international levels, we will have a glut. Hence, for agriculture too, good management will prevent inflation. Thus, in all three cases, inflation can be attributed to poor management. In 1991, India embarked on an era of liberalisation. We can see resultant benefits in the phenomenal improvement in quality (and decrease in prices) in the liberalised sectors of the economy. Unfortunately, even as parts of the economy were liberalised, our government has tightened its control of education. It has refused to liberalise real-estate. Farm sector too is riddled with restrictions.

Poor Management

Suppose quality of supply of engineers (and other specialists) had kept pace with demand. Would salaries have increased as rapidly as they are doing now? Suppose building construction had spread out to cheaply available vast areas of wasteland.

Would there have been inflation in real-estate prices? Suppose agriculture had been modernised. Would there have been either shortage in farm products or inflation in their prices?

In other words, the current inflation is primarily the result of poor management of education, real-estate and agriculture.

Drawing from the results of liberalised areas of the economy, we may conclude that the management reform we need most is liberalisation of our education system, real-estate business, and agriculture too. With all three liberalised, we can expect both low inflation and rapid growth.

Intelligent taxation

Liberalisation and improved management take time to produce results.

The fruits of liberalisation of the early 1990s became visible only a decade later.

Unfortunately, inflation is here and now. It needs a quick fix. For inflation, intelligent taxation appears to be the best band-aid. However, the tax should be applied selectively, where it is needed most. It should not fall like rain on the sinner and the saint alike.

Inflation becomes persistent, not when households spend a lot but when they spend more than in the previous year.

A software engineer does not cause inflation by spending a million rupees but by spending a hundred thousand rupees more than last year.

Hence, it is not high incomes but increases in consumption that cause inflation. It is not easy to measure increases in consumption, but increases in disposable income (total income less savings) are easy to assess; they can be taken as the substitute.

Then, suppose we impose a tax on increase in disposable income over the previous year. Such a tax is selective; it will directly attack excessive consumption. It will not fall on the spendthrift and the thrifty alike the way increasing the bank rate does.

Inflation due to cost increases can happen in two ways: Exogenously, as in the case of crude oil price increase or when drought occurs; we can do little in such cases.

Inflation caused by mismanagement is a different matter altogether. Management can always be improved. In this case, problem is bad politics not bad luck.

Spending more to get less

Common sense dictates that money should be invested where its purchasing power is highest. As the purchasing power of the rupee is less in cities than in villages, we should maximise investment, particularly real-estate investment, in the rural areas.

Our policy is exactly the opposite: We construct more and more in or near metros where real-estate is most expensive.

For these reasons, I propose two new taxes for curbing inflation: One, a tax on the increase in disposable income (total income minus savings) over the previous year; two, a tax on construction on land whose value is higher than, say, Rs 1,000 a square yard (0.836 sq m).

Unlike monetary measures, such as raising the Bank Rate or the CRR, such taxes will hit only the culprits, and spare the rest. They will not slow growth the way monetary measures will. As a bonus, they will reduce fiscal deficit. However, these measures are only palliative; they will relieve the pain of inflation but not inflation itself. Inflation will be cured only when we improve the management of our economy by liberalising education, real-estate and agriculture.

The government should control or regulate each of the three areas only to the extent of ensuring transparent competition. Then it will combine low inflation with fast growth; ensure better quality of life too none of which a hike in interest rates or the CRR can guarantee.

(The author is a former Director of IIT Madras)

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