To cut Income tax or not to cut Income Tax

In today's newsletter, we talk about the biggest rumor in town. Will the government cut income tax rates? And more importantly, is it prudent for the government to cut tax rates at all?

The Story

With the Budget Day now in touching distance, there have been rumours flying about a potential cut in income tax rates. Now, most people I know are fully excited about the tax cuts that might be coming their way. Because, why wouldn’t they? It's free money.

However, the question becomes very complicated when you pursue a utilitarian approach — Will this benefit the group, the nation, the people of India? Will this help in pulling the economy out of its slump? Is an income tax cut by definition, anti-national?

Well, to answer that, we need to look at some of the arguments put forward by the naysayers — those who contest that a cut in income tax is a win-win for everyone involved. So let's start with a curve. A very special kind of curve.

The Laffer Curve

The premise is simple. When the government moves the effective tax rate to 0%, the government makes no money. This is pretty evident. How can the government make money when you don't pay any tax? But note that the government makes no money when it moves the tax rate to 100% as well. Because, if the government takes away everything you own, what’s the incentive to keep working eh? So people will work less. They'll make less money and so the government will have very little to tax. And even if you did work hard, you would probably choose avenues to hide your income, so that you don’t have to file taxes. So the sweet spot (for tax rates) is between 0% and 100%. And if you were to plot a graph mapping the total government revenue at different tax rates, you’d get a graph similar to the one you are seeing below i.e. The Laffer Curve

So, some people contest that reducing the tax rate might actually boost government revenue by way of getting more people into the taxable bracket. However, the graph is a bit misleading because it doesn’t tell you anything about the optimal point. It just tells you that there is one. That’s it. Note how the markers in the X-axis are conspicuously absent. So how do we know where we are on the curve right now?

As Jordan Ellenberg writes in his best selling book, How not to be wrong?

“All the Laffer curve says is that lower taxes could, under some circumstances, increase tax revenue; but figuring out what those circumstances are requires deep, difficult, empirical work…

There’s nothing wrong with the Laffer curve — only with the uses people put it to. [The people that believe lower tax rates will automatically boost government revenue] seem to fall prey to the oldest false syllogism in the book:

It could be the case that lowering taxes will increase government revenue;

I want it to be the case that lowering taxes will increase government revenue;

Therefore, it is the case that lowering taxes will increase government revenue.”

Sorry, sir. But this is fallacious thinking.

Stimulate Thy Demand

Even others contend that while low taxes might not necessarily increase government revenue, it does boost an individual’s disposable income. And the theory posits that some of this extra income will inevitably be spent (and spent well) thus providing the necessary fillip to the production side. Ergo, you fix the demand side and the supply side will fix itself.

While this might seem like a very compelling argument, you have to remember that India has a very small tax base. Only around 7.4% of adults (aged 15 years and above) in India file or pay income tax. So to assume that this small group of people will suddenly spur the consumption engine to life is wishful thinking at best. But then, what happens to the extra disposable income. In 2017–2018, total Income tax collections added up to about 10 lakh crores. That’s a lot of money. So any prudent analysis of the demand and supply-side dynamics here must account for this extra income. Fortunately, for us, it doesn’t take a genius to figure this one out. Because if you are not spending most of this money on consumables, you’ll probably be saving it elsewhere. And while India’s savings rate has plummetted in recent years, not everybody is convinced that the savings push will magically solve India’s problems.

Yes, benefits do accrue when Indians save more. Because your savings will move through multiples channels in the financial ecosystem. Banks will have additional buffers, the mutual fund industry might see extra inflows and sure, some of this money will make its way into the formal economy by way of loans and investments. But if the basic premise is that the demand side is now broken, we need the large bulk of the informal sector to start driving the recovery. Unless the extra savings makes its way into the informal (largely agrarian) economy, it’s unlikely we will see any meaningful pick up in consumption.

And then there is another problem. Once you cut income tax, reversing it will be a challenging task for any government, even one that enjoys considerable support in many circles. The government’s finances are already in a precarious state. Foregoing additional revenue in taxes is a death knell. And while it might benefit the individual, I am not convinced it does a whole lot of good for the collective.

In any case, we will know for sure if the government will cut tax rates come February 1st. And considering I am not exactly the utilitarian types, I will be battling for a cut in income tax either way.

Until then, stay safe.

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Also, the Supreme Court has finally reviewed the AGR verdict and stated that the Telcos have to pay their dues. So if you are looking for a refresher course on the whole saga check out our story on AGR from October.