What is Fiscal Capacity?

It’s simply ability to generate revenues. As majority of the revenue of governments around the world is through taxes (other from various fees/user charges/ dividends etc), Tax to GDP ratio is often taken as proxy for the fiscal capacity of a govt.

Survey argues that state capacity and taxes are crucial determinants of long run political and economic development. But Why?

Govt can only spend as much as it earns (plus some limited amount of borrowings). So fiscal capacity i.e tax to GDP ratio also determines it’s spending capacity.

Political development-If spending is about the entitlements of citizenship in a democracy, taxation is about the obligations of citizenship <rights and duties>. As more and more people come into the tax net via some form of direct taxation <in indirect taxation, people don’t feel like they are paying. Don’t we all generally think, only some 4% of India pays tax while every one who buys something pays some form of indirect tax>, they will more actively take part in nation building<their money is at stake>.

Economic development- Democracy is a contract between the state and its citizens. The state’s role is to create the conditions for prosperity for all by providing essential services <such as law and order, enforcing contracts, roads, transport, health, education etc, for instance without enforceable property rights markets can’t function> and protecting the less well-off via redistribution <subsidies etc, providing minimum standard of living and reducing inequality>

What is citizen’s role in this contract?

• The citizen’s part of the contract is to hold the state accountable when it fails to honour the contract <provide essential services and redistribute to reduce inequality>
• But a citizen’s stake in exercising accountability diminishes if he does not pay in a visible and direct way for the services the state commits to providing <esp essential services. He is not paying, what does he care if state does not provide>
• If a citizen does not pay he either becomes a free rider (using the service without paying) or exits (not using the service at all). Both reduce the accountability of the state.

For instance, not many taxpayers send their children to state run schools i.e exit from the service, thus reducing accountability which leads to further deterioration in the quality of schooling. They simply don’t have stakes in the system. That’s why some promote banning or reducing to the minimum the role of private sector in primary education. And it is for this reason that Allahbad High Court ordered public servants to compulsorily send their kids to Public school. Indian express link here <whether order was complied with or not, I have no idea, May be UP wale can help us>

Taxation is not just about financing public spending, it is the economic glue that binds citizens to the state in a necessary two way relationship.

Precocious Indian phenomenon of economic development lagging political development

In terms of democracy index, India is highly developed with periodic free and fair elections, a very noisy and vibrant democracy but in terms of economic development India lags far behind the OECD countries.

Difference in taxpaying <only 4% of voting age population paying direct tax> and voting <universal adult franchise with >60% voting> might explain the phenomenon in India of there being reasonably effective episodic accountability <regular elections with non performing govts being shown the door> as opposed to ongoing accountability <reflected in corruption, law and order problem>.

• For instance, there has not been a single famine in independent India <Amartya Sen’s famous theory that famine simply don’t occur in democracies as they can’t afford it. Govt will simply lose power after a famine> but malnutrition remains a major challenge <discussed in chapter 4, women and children>. <Reason is simple, malnutrition is not as dramatic as famine so doesn’t attract media attention and in India accountability is episodic not ongoing>.
• Or the Indian state can organize mega-events <commonwealth games, gigantic elections> but routine safety for women is not ensured.
• Or state responds effectively to floods and tsunamis but finds water and power metering more challenging <can not perform routine tasks which calls for ongoing accountability but performs heroically in dramatic events which remain in public memory and thus public enforces accountability at the time of election i.e periodic accountability>

So does India tax and spend less as liberals/ left leaning commentators (Amartya Sen and Dreaze argue)?

Learn these facts and analysis by heart and reproduce them in essay / general studies /interview.

• India taxes (16.6%) and spends (26.6%) less than OECD countries (34% and 43%) and less than its emerging market peers (21% and 31%)
• For it’s level of economic development (countries with similar per capita income), India does not  tax and spend less
• But controlling for both the level of economic and political development (democracy), India seems to tax less and spend less and this is most significant with respect to social expenditure (on health and education) 
• India spends on average about 3.4 percentage points less vis-à-vis comparable countries on health and education <that’s a huge amount, India spends about 3.3% of GDP on education and 1.3% on health i.e 4.6% total while comparable democracies at similar level of economic development spend 8% on health and education>

Democracies tax and spend more, in part because they face greater pressures to redistribute and India lags behind here.

India’s tax to GDP ratio has increased by about 10% over the past six decades from about 6% in 1950-51 to 16.6% in 2013-14 (very slow growth)

This analysis seems like indictment of the Indian development experience since India has been a democracy for nearly 70 years. But in most of the advanced democracies, the big increases in fiscal capacity have been in response to wars (world wars) or in response to extreme crises (Great Depression of the 1930s) which led to a sharp expansion of the welfare state and the need to finance it. Independent India has not experienced shocks of such large magnitudes that created pressures to enhance state capacity.

western democracies have also had a much longer period of political evolution <USA became republic in 1789 v.s Inda in 1950> allowing them to build state capacity <taxation and expenditure institutions>

Now that we have established India taxes and spends less compared to other democracies, should India start taxing and redistributing more?

• The history of Europe and the US suggests that typically, states first provide essential services (physical security, health, education, infrastructure, etc.) before they take on their redistribution role. Why?
• Because unless the middle class in society perceives that it derives some benefits from the state, it may be largely unwilling to finance redistribution
• In other words legitimacy to redistribute is earned through a demonstrated record of effectiveness in delivering essential services
• if the state’s role is predominantly redistribution, the middle class will seek to exit from the state, will avoid paying taxes and coccon themselves in walled communities <state’s redistribution role is perceived as illegitimate as they pay taxes but state can’t even provide them essential services such as infrastructure, law and order, decent primary education>

As we saw earlier, in India they already send their kids to private schools thus reducing the pressure on the state <ongoing accountabilty is absent, lower class i.e poor are unable to hold state accountable for they don’t even have enough time to invest in these matters>. They thus reduce accountability and legitimacy of state even further.

A state that prioritises or over-emphasises redistribution without providing basic public goods, risks unleashing this vicious spiral.

Point is that India should invest more in essential services, law and order, infrastructure, pollution, congestion, health, education to earn the legitimacy before taking on big re-distributive role.

Number of taxpayers in India (Too few or adequate)

In India roughly 5.5% of earning individuals or 4% of voting age population is in the tax net.

Controlling for level of economic development, India does not have too few taxpayers but again if we compare India with countries with similar level of income but those who are democracies (political development), India seems to have too few taxpayers. It should be 23% while India only has 4%.

Top personal income distribution (Inequality in India)

Inequality is generally measured by Gini coefficient (more on that in separate back 2 basics economics article some other day). Other measure is to compare income of top quintile (20%) with bottom quintile (20%). But of late, greater focus has been on income and wealth of top 1%, even more of top 0.1%.

We can see from the figure below that increasingly there is greater concentration of income among top 1% and even more so among top 0.1%. In 2012 top 0.1% held 5.1% of national income up from 3.6% in 1998.

Moving To A Better Equilibrium On Taxation And Spending

India has not fully translated its democratic vigour into commensurately strong fiscal capacity <As we saw India taxes and spends less among democracies>

Reform through inaction — Do not increase exemption threshold. As income rises, more people would automatically come into tax net.

Additional 1.65 crore people would have been in the tax system and tax-GDP would have increased by 0.32% by 2013 if govt had not raised exemption threshold from 1.50 lakh to 2 lakh.

But beyond this low hanging fruit of not increasing exemption limit, to increase fiscal capacity (tax more) state must also increase it’s legitimacy.

• Government’s spending priorities must include essential services that all citizens consume: public infrastructure, law and order, less pollution and congestion, etc.<so that middle class does not exit v/s redistribution>
• Reducing corruption must be a high priority not just because of its economic costs but also because it undermines legitimacy<if citizens think public resources i.e their hard earned money going for taxes is being wasted, they would try to avoid paying taxes>
• Subsidies to the well-off (1 lakh cr, disccused in chapter 6) need to be scaled back.
• Tax exemptions Raj which often amount to redistribution towards the richer private sector will also need to be phased out. <govt announced phasing down of exemption and reducing taxes but not much guidance from the budget>
• Reasonable taxation of the better-off, regardless of where they get their income from—industry, services, real estate, or agriculture–will also help build legitimacy<presently agri income is not taxed and we all know politicians show all their black income as income from agriculture and plantation>
• Property taxation needs to be developed. Property taxes are especially desirable because they are progressive <rich owns more property, will pay more>, buoyant and difficult to evade, since they are imposed on a non-mobile good, which can with today’s technologies, be relatively easily identified.

Higher property tax rates can be the foundation of local government’s finances, which can thereby provide local public goods and strengthen democratic accountability and more effective decentralization. It would also put sand in the wheels of property speculation. Smart cities require smart public finance and a sound property taxation regime is vital to India’s urban future.

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