Making the State Impotent

On liberation from the imperialist yoke after the Second World War, many countries embarked on the path of economic development to make their political freedom secure and meaningful to their people. Even though these countries were at different levels of development, almost all of them were socially and economically backward. Modern manufacturing industries and infrastructure facilities were meagre or completely non-existent. Backward agriculture along with extractive industries dominated the economies of most of these countries. Vestiges of feudalism were big impediments in the way of modernization. They lacked technically qualified manpower and the level of education was very low. Health services were deficient, epidemics and diseases along with malnutrition pushed up the death rate.

There were two courses open to them. They either pursued a dependent course or tried to build an independent economy. If they opted for the latter course, they had to face enormous difficulties concerning capital accumulation, narrow home markets, and a lack of trained and technically qualified personnel besides an unjust external economic environment. These difficulties could not be solved without an active involvement and leading role of the state because the indigenous capitalist class was either non-existent or feeble.

Pursuing this course has yielded impressive results in countries like India. Yet, this has not been to the liking of their erstwhile subjugators and the institutions like the World Bank and the IMF. In the course of time, willy-nilly they have come to give up their frontal opposition to the leading role of the state and have been trying to make it complementary to the market. In other words, it is to be facilitator, not regulator. To quote the World Bank, “Development – economic, social and sustainable – without an effective state – not a minimal one – is central to economic and social development, but more as a partner and facilitator than director. States should work to complement markets, not replace them.” (World Development Report 1997, p. 18).

The ten propositions of the Washington consensus of 1990 clearly rejected any activist role for the state. In fact, a serious and concerted attempt was made to curb its initiative. Besides privatization of state enterprises and deregulation, an important instrument mentioned was fiscal discipline. In fact, the last was aimed at making the state impotent. The work in this direction had begun much before John Williamson came up with his Washington consensus. The pioneer in this regard was Arthur Laffer whose “Laffer curve” was lapped up by Margaret Thatcher and Ronald Reagan. An aura was built around this gentleman who was proclaimed a great genius. Developing countries were told to pay heed to it.

Arthur B. Laffer is the founder chairman of the Laffer Associates, an economic research and consulting firm. He has been described as “the father of supply-side economics”. He was a member of Reagan’s Economic Policy Advisory Board for 8 years. He taught at a number of universities. A legend was propagated about the origin of the Laffer curve. It is said that in the winter of 1974, Laffer, then a young and energetic economist from the University of Chicago, the citadel of neo-liberalism, was having dinner with Jude Wanniski, then associate editor of The Wall Street Journal, at the Two Continents Restaurant of the Washington Hotel, Washington, D.C. Other friends at the table were Donald Rumsfeld and Dick Cheney who need no introduction. Wanniski in his article “Taxes, Revenues, and the ‘Laffer Curve’” (The Public Interest, Winter, 1978) has given a vivid description of what transpired there. In the course of discussing President Ford’s “WIN” (Whip Inflation Now) proposal for tax increase, Laffer is said to have taken out a napkin and drew and drawn a curve showing the trade-off between rates of taxation and the likely yields of tax revenue. Wanniski claims it was he who named it “The Laffer Curve”.

It depicted the basic idea behind the relationship between these two variables. The changes in tax rates have two effects on tax revenue, namely arithmetic effect and economic effect. The former implies that if rates of taxation are reduced, the revenue yield will pari passu go down. The reverse will happen if tax rates are increased. The economic effect takes into account the impact on incentive to work, output, and employment. It is claimed that the lower rates of taxation lead to positive results. The higher the rates of taxation the less is the incentive to work, increase output, and create employment opportunities. In fact, higher rates of taxation penalize the hard working and innovative people who are honest. They prompt the dishonest to indulge in evasion and avoidance of tax liabilities.

The Laffer curve was soon lapped up by the votaries of supply-side economics and it was asserted that it gave a very important message to governments that they could raise higher amounts of tax revenue by reducing tax rates. It was this argument that led to the Thatcher government and the Reagan administration to resort to lowering the tax rates. The Fund-Bank began impressing upon developing countries to follow suit. Many economists doubted its validity in the case of developing countries as they were still at a point on the curve at which raising tax rates would boost revenues. Moreover, the Laffer curve lacked sound empirical evidence.

The Laffer curve is supposed to demonstrate that a government could maximize its tax revenue by fixing the tax rate at the peak of this curve beyond which raising the rate will actually reduce the tax yield. The idea behind the curve is very simple. At both 0% and 100% rates of taxation, the government cannot get any revenue. At 100% tax yield is nil because in a rational economic model prospective taxpayers will either completely lack any incentive to work or will evade and avoid tax payments. Obviously, somewhere between these two extremes will lie that unique point where tax revenue will be the maximum and yet there will be no adverse impact on the incentive to work, total output and employment generation.

It is interesting to note that Laffer himself does not have any recollection of drawing the curve in a restaurant on a napkin nor does he claim any copy right to the idea behind it. In fact, he attributes it to the 14th century Arab scholar Ibn Khaldun and the 19th century French economist Frederic Bastiat.

Ridiculing the doctrine that the rich are not inclined to working because they have too little money left with them after taxation and the poor because they have too much, and its embodiment, the Laffer curve, Prof. John Kenneth Galbraith has this to say in his novel A Tenured Professor (1990, pp. 75-76): “This economic formulation … held that when no taxes are levied, no revenue accrues to the government. An undoubted truth. And if taxes are so high that they absorb all income, nothing can be collected from the distraught, starving and otherwise nonfunctional citizenry. Also almost certainly true. Between these two points a freehand curve, engagingly unsupported by evidence, showed the point where higher taxes would mean less revenue. According to accepted legend, the original curve had been drawn on a paper napkin, possibly toilet paper, and some critics of deficient imagination held that the paper could have been better put to its intended use.”

The Laffer curve came handy to those who were attacking, day in and day out, Nehru and his successor for making India “The Highest Taxed Nation”, thus stifling the initiative and effort of the rich desperately wanting to make India a great and prosperous nation via “Trickle-down Strategy” of income distribution! Their persistence and the support of the Fund-Bank via the Washington consensus to them ultimately convinced the government to lower the marginal rate of taxation that has ultimately come down to just 30 per cent from 97.5 per cent. There is, however, no proof that the tax yield has gone up in real terms. Not only the rates of personal and corporate taxation have been brought down substantially but also the import duty has been substantially reduced. On the top of it, a law was enacted during the last year of the BJP-led NDA government. It is called the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. It came to be operationalised with the notification of its rules in 2004 by the present Manmohan Singh-led UPA government. Thus there does not appear much difference between the two ideologically opposed governments as regards following the Fund-Bank philosophy as embodied in the Washington consensus. Under the provisions of this Act and its rules, the government is mandated to eliminate revenue deficit by March 2009. It is under intense pressure to phase out subsidies of all kinds and also the programmes for the weaker sections of the society. The government has already given up its role in expanding public enterprises and running the old ones indefinitely. The purpose of fiscal policy has undergone a drastic change. In short, the aim of making the state impotent has been achieved so far as India and many other countries are concerned. Obviously, this will have far reaching consequences for social, political and economic stability.

Now, a vigorous move is afoot to bring in flat rate of taxation presumably to eliminate cumbersome tax administrative machinery and put an end to tax evasion and avoidance. Three arguments are being advanced in its favour, namely, every income group will gain, it will simplify tax administration, and it will boost savings. Surprisingly, there is no debate on this in India.

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