Go for `Laffer curve’ to boost revenue

With the Union Budget round the corner, there will be discussions and debates by individuals and corporates alike as to what to expect from the finance minister. These expectations are a yearly ritual but hopes are high among individual taxpayers this time around after the finance minister cut the corporate taxes sharply in August 2019.

Hopes are also high because of other macro factors affecting the state of the economy. The RBI has cut the growth forecast to 5% from 6.1% for 2019-20. Though GST collections crossed the Rs 1 lakh crore mark for November and December 2019 after falling short for three consecutive months, they are still below the target and there are demands from the industry for further changes in GST structure.

The RBI conducted an unusual “Operation Twist” a few days ago when it purchased Rs 10,000 crore worth long-term government securities and sold Rs 6,825 crore short-term securities through the special open market operations injecting liquidity into the system. The measures were necessitated to revive demand and kick start the economy. Against this “gloom and doom”, the common man feels that it is just a matter of time before the finance minister stops kicking the can down the road on personal income tax rates.

With the government slashing corporate tax rate to 22% from 30% for existing companies and to 15% from 25% for new manufacturing companies in August 2019, the effective tax rate including surcharge and cess for existing companies has now come down to 25.17% from 35%. This move will result in revenue loss of Rs 1.45 lakh crore to the government and so there is very little room for further cuts on this front.

In GST reforms, the finance minister is unlikely to go in for a two-rate structure from the present five rates. As far as the personal income tax rates are concerned, we have a progressive taxation system where in the tax that individuals pay increases from 5% to 30% depending on their taxable income.

In addition, the taxpayers also have to pay health and education cess of 4% on the tax liability.

Individuals having income above Rs 50 lakh have to pay a surcharge of 10% also along with the cess. The surcharge for FY19-20 is 15% for income above Rs 1 crore but below Rs 2 crore, 25% for income above Rs 2 crore but below Rs 5 crore and 37% for those whose income is above Rs 5 crore.

This means that the effective tax rate (including cess and surcharge) is 39% for individuals having income between Rs 2 crore to Rs 5 crore and 42.74% for those having income above Rs 5 crore. The intent of the tax laws is that taxpayers with deeper pockets can afford to pay more taxes and hence by taxing them more the government can earn more revenues. The message it conveys on the contrary is that it is a sin to have more income.

Do high taxes lead to more revenues? No, if economist Arthur Laffer is to be believed. It was in this context that he, through the Laffer curve, suggested that high taxes in fact generate less revenue as it discourages people to work.

Hiking taxes

Laffer, during a meeting with White House administrators Dick Cheney and Don Rumsfeld in 1974, suggested that that the federal government’s proposal to hike taxes to increase revenues in the wake of recession in the economy was not a good idea.

To elaborate his point, he drew a graph on a paper napkin and explained that increasing taxes beyond a point instead of increasing revenues reduced incentives for individuals to work and businesses to invest and reduce revenues. The curve that he wrote later came to be called as the Laffer curve. He contended that if the government really wanted to kickstart the economy and therefore government revenue, tax rates should be cut.

President Ronald Reagan seemed to have been influenced by Laffer’s curve when he implemented tax policies. The Laffer curve shows the relationship between tax rates and revenues. The shape of the curve explains that as tax rates rise, tax revenues will also increase.

However, the tax revenues will increase until a peak after which, they begin to decline sharply. Therefore, after a point increasing tax rates is counterproductive. When the tax rate is 100%, people will have no incentive to work. If tax rates decrease, leisure time becomes more expensive and people tend to work more.

Political parties use the concept behind the Laffer curve to justify tax cuts – that lower tax rates mean businesses and households will spend more, create demand and boost economic activity.

So, the loss of tax revenue is compensated by the uptick in consumer and business activity. For a change, good economics is good politics here.

The finance minister has cut corporate taxes. The slowdown can be used as an excuse for both increasing and reducing personal income tax rates. Hope there is a silver bullet for all the ills confronting the economy.

(The writer is a CFA, a former banker and currently teaches at Manipal Academy of Banking)