It seems like there were rumors afoot about demonetization back in March 2016. Mr Ghosh the chief economist at State Bank of India published this article speculating that currency circulation was up as people were taking steps to convert currency to jewelry, gold and gems. In hindsight this was prescient analysis. People went to extraordinary lengths to avoid taxes…
There are typically three reasons to avoid taxes
- Taxes are too high
- Free rider effects – people believe that they can get away without being caught
- “Taxation without representation” – people do not feel they have a stake in the decisions made about their taxes
In India the highest tax is 30%, not very high compared to other countries. In the US the highest rate is closer to 40% with additional state income taxes. The rate is not too high by any standards. That does not appear to be a reason to avoid taxes.
Some data: In India only 4% of adults file tax returns (29 million out of 720 million). Of these half pay no taxes. So only 2% of the adult population is paying any taxes. There are only about 18000 individuals out of 1,250,000,000 with reported income greater than Re 1 Cr (about $150,000). And only 6 with a reported income greater than Re 50 Cr (about $7.5 million). The size of the Indian economy is about Re 150,00,000 Cr (about $2 Trillion). This in sharp contrast to a consumption economy that has big sales of luxury cars, property, international travel, lavish weddings, gold and gem consumption. It is clear that taxes are being avoided on a large scale. The reason this is widespread is that the taxman is ineffective, legal processes slow, accountants are creative and corruption through bribes and corruption through relationships are widespread.
In Indian culture exchanging favors is the way to build relationships. These relationships are the most important element of wealth. Key relationships to cultivate are with politicians, judges, doctors, government officials, bankers. Anyone who has access to power and influence. These networks of relationships are constantly exercised to undermine the rule of law. What this means in practice is that “knowing” the right people is the differentiator in business and life.
An interesting effect of this culture is that companies get into diverse fields – IT, healthcare, media, garments, steel, …it is not surprising to find industrialists operating across all these areas. Question is how can they gain the competence and competitive edge to compete in so many areas? Are they all renaissance geniuses? I think the answer is that the true competitive edge lies with the relationship networks they have. These give them an advantage in any field they decide to compete in. Cartels of the rich, politicians, government officials and public sector bankers exploit their advantage to gain enormous success.
In this environment of “trust” and “relationship” based cartels, money is a way to lubricate the system. Every person who has control on a public resource or decision uses this power to extract rent. In fact money may be a way to break the power of the cartels and create a more even playing field (it may sound crazy but bribery may actually be a democratization of this access over the tight relationship cartels). The net result is that enforcement of anti-corrupt laws is a blunt tool. So the free rider effect is strong and tax avoidance is high.
The narrowing of the tax base is a global phenomenon. With increasing gap between the rich and poor tax revenues are collected from the few and services provided to many. This has two effects –
1. The vast majority of taxes are collected and decisions made to spend them in places far and distant from where the collection happens.
2. People see little benefit to their lives from the taxes that they pay.
The large cities contribute the bulk of the taxes in India. For example Mumbai alone contributes 30% of the income taxes collected in India. Together Delhi and Mumbai about 40-50%. This sort of skewed tax collection means that tax payers see little benefit from their taxes in their day to day lives. Instead of civic participation it seems like extortion. People can easily create moral justification to avoid paying taxes because they are “wasted” anyway. In the US revolution started with protest over “taxation without representation”. Tax avoidance is a form of the same protest.
It may be that Indian tax collection is too centralized to be effective. The right direction could be to decentralize tax collection and spending decisions. If Delhi and Mumbai could keep a fractionally larger share of their taxes they could grow significantly faster with better infrastructure and better business conditions. This would also create incentives for citizens to participate more willingly in tax collection. A city centered tax collection and administration regime where the cities compete with each other for providing the best business environment could reverse the dynamic of avoiding taxes at any cost. It would begin to realize the founders dream of local self government.
Similarly opening up tax collection in villages from rich farmer income, to local panchayat would do the same by giving everyone some “skin in the game”. There could be some redistribution but a little less than today. This could increase tax compliance and improve the use of tax money and quicken the pace of development. The overall tax base and collection could rise faster with better utilization of tax money to alleviate constraints and investments in the lives of people. A beneficial side effect would be to make local politics became more responsive to the nuts and bolts of managing the commons rather than dramatic emotional issues.
The difficulty is getting the politics to work.
Focus 