As India’s Inequality Spirals, How can the Government Step in and Intervene?

If done immediately, policies of targeted taxation of income, wealth tax and inheritance tax may provide a lifeline for those who have fallen behind.

(Note: This is the second in a two-part series on inequality in India. Read the first here).

Is there any hope? The price of not doing anything about the inequality is very high. Concentration of such high income or wealth with such a small percentage of people will mean the wealthy will capture politics, the Government and democratic institutions. And this doesn’t even include the debilitating effects of crony capitalism which are likely to ensue.

In terms of wealth inequality, data is even more sparse as India does not collect wealth statistics.

But wealth is substantially more concentrated than income. Credit Suisse, a financial institution has estimated wealth share of India’s top 1% to be 53%.

Can this distribution problem be mitigated?

If ‘equality of opportunity’ is in denial mode, turbulence as a consequence is inevitable. Data shows that unemployment rate is higher among those with education level higher than secondary. This is because of low quality higher education. which has created a situation of unemployment rate increasing with the rise of education. For mitigating inequality of this order, young people require access to reasonable quality education and health and access to quality jobs. Education is long considered to be a ticket to social mobility. But poor quality education and health care in public institutions gives a head start to people in the top bracket as elite devise their own coping mechanism outside the public system.

At the current level, governments lack resources and lack capacity to expand services and to have policies and institutions to effect changes for giving a chance to people who deserve it but are deprived.

On the side of the plutocrats, there is no attempt to correct the course. Their idea of creating an out of box solution is to start a university for the elites with hefty fees or to start hospitals where high cost makes health services unaffordable. This is passed on as efficiency based business model. Decent jobs get replaced by casualization in the name of competitive necessity.

Their philanthropy and charities range from scattered effort of no consequence to neatly packaged publicity which has business interest embedded like a Matruska doll. CSR is a tepid effort like a palliative. Ordinarily, countries have only two options. Either their society is more equal to begin with and the Government does not need to do much or  if unequal,t he Government runs an elaborate transfer programme after taxing the rich. Transfer programmes per se have their problems of moral hazard and disincentivising effort. It also requires resources and capacity building within the Government.

For anything to be done by the State credibly, augmentation of resources and state capacity is necessary. Instead of expanding the menu of transfer programmes, it will be appropriate to provide quality education,  quality healthcare, nutrition cover and skill development for quality employment. But these require resources and capacity. The transmission effect of investment in these broad sectors will be hugely equality enhancing.

Any proposal of taxation will inevitably be resisted with apparently plausible arguments. The arguments will be that the wealthy create jobs; that the smart and hard working people among the bottom half will move up and the trickle down effect will work; that the present rich and wealthy earned because of their entrepreneurship and risk taking ability and their success should not be grudged etc. But if we examine each of the argument deeply, arguments will appear thin.  

Jobs are created by an ecosystem when consumers increase their income and number. Since they get ready to buy, the rich find it worthwhile to produce and sell. Given our inequality, both the consumer base and consumer income is unlikely to be increased at a fast clip at the bottom of the pyramid as it happened in China. It could also hurt the rich in the process. It is not true to say that smart, hardworking and deserving people always move up. Incredibly hardworking people often don’t move up because the dice is cast against them to begin with. Success and lack of success are not entirely deserved. So called equality of opportunity is denied to them be it education or health care because the quality of public institutions where they have some access is extremely poor. The argument that rich earned their profit because of their ability, application and risk-taking ability is highly questionable. Most of them are not product of innovation, Majority of persons in top 1% earned their wealth and income because of inheritance supported by opportunities of crony capitalism, monopoly situation, rent seeking behavior or at least predatory practices.

For remedying the position it is often suggested that taxation should be progressive. Given that 9% of the adults below top 1% have an average earning of $12,000 to $20,000 PPP, which essentially means a middle class in a middle income country, introducing progressivity will be an overkill. Instead it is desirable to have a targeted taxation of top 1%. This category has 8 million people.

Ruchir Sharma found out that out of the 2.5 lakh dollar millionaires only 42000 file tax returns. First thing is to make sure that all 8 million come under the tax bracket. Targeted taxation of the top 1% should be at least 20% to 30% more as in many countries which follow equity enhancing policies.

The policy of reduction of corporate tax is a bad policy for reducing inequality. Corporate tax is levied from the surplus after deducting dividends. Change in the net worth represented by retained earning is taxed. If it is not taxed, retained earning increase the value of the share. If not taxed retained earning is not guaranteed to flow into investment. Major shareholders are principal beneficiaries of the share price increase because of retained earning and dividend payment. With several exemptions in place, reduction of corporate tax will reduce the state capacity and will give gains to already wealthy. Coupled with low capital gains tax, there is an incentive for accumulating capital within the firm. This results in holders of capital earning inordinately high rate which diverges from the growth rate of the economy and is likely to exacerbate inequality further.

With such skewed distribution of wealth, wealth in excess of say Rs.30 crore should be taxed at a low rate of 1% of the property and capital value per annum until the monetization of wealth takes place. Existing 2% surcharge on income is no substitute to a tax which is on concentrated wealth and which is likely to deepen. With Aadhaar, it should be possible and easy to tax higher wealth by tagging properties. Similarly inheritance tax needs to be brought back. A rich inheritor is more likely to do well because of transmission effect, starting from education to job whereas a more meritocratic non-inheritor is likely to lose out.

In a democracy, inheritance cannot be the basis of doing good in life. Wealth tax was abolished in India because of complexity involved in the collection process and also U.S. had abolished it. For inheritance tax to function, robust mechanism that validate real assets holding must emerge through Aadhar and PAN card tagging. While reasonably generous exemption should be put in place with threshold which provides one house and some capital inheritance, say about 10 crores rupees along with low tax rate can be a starting point. No inheritance tax on same generation transfer will encourage compliance. The law should make family trusts within India taxable and prohibit creation of family trusts abroad.

It is true that government cannot control the market forces. Governments also tend to do a bad job when they interfere in the functioning of the market. But through policies and institutions, Governments can shape the market forces. Market forces are not secular or sui generis. They arise out of policies. What exists today cannot be taken as an immutable law of nature.

India’s inequality is unconscionable now, even if the pikes are yet to come out, action should be taken to prevent further worsening. Such inequalities are known to snuff out growth prematurely despite Pareto Optimal argument that no one is becoming worse off.

Policies of targeted taxation of income, wealth tax and inheritance tax to finance quality public education and health care, providing nutrition cover and skill training may provide a lifeline for those who have fallen behind. The time to act is now.

Satya Mohanty is a former Secretary to GOI and currently an Adjunct Professor of Economics, Jamia Millia Islamia.