India’s Faustian Fiscal Bargain—Part I

by Arvind Subramanian, Peterson Institute for International Economics

Op-ed in Business Standard, New Delhi
September 22, 2007

© Business Standard


See also Part II of India’s Faustian Fiscal Bargain.

Democracy as a political experiment might well earn India a B-plus/A-minus grade, perhaps even a notch higher, if account is taken of the inhospitable initial conditions for the “leap of faith for which there was no precedent in human history,” as Pratap Mehta puts it in his brilliant and insightful book, The Burden of Democracy.

But democracy’s economic record—specifically, in providing basic public goods such as law and order, and essential services such as education, health, water, and insurance for the majority of Indians—would barely obtain a passing grade. How did we get here? And, more importantly, how do we get out of here?

If “no taxation without representation” was a rallying call for many an uprising against a colonizing or other unjust power, one of the deeper truths about economic development is captured in its mirror image that there can be “no representation without taxation.”

Taxation is a glue that binds citizens and states to create civic engagement and productive two-way interaction. Because governments need to tax, they have an incentive to facilitate wealth creation (which provides the tax base) and hence to guarantee rule of law, protect property rights, and ensure sanctity of contracts. And because citizens are taxed, they have an incentive to hold governments accountable for the promises they make; in some ways, taxation may even be superior to elections because regular elections create the conditions for episodic accountability, while taxation provides the incentive for citizens to hold governments accountable on a more ongoing basis.

The natural resource curse—the regularity that countries with large amounts of oil and other natural wealth have either poor political institutions (think of countries in the Middle East) or economic institutions (Indonesia for example) or both (Nigeria and Venezuela)—is actually an illustration of this deeper truth about taxation and development. When governments have access to natural resource wealth (or to large amounts of foreign aid), they have little need to tax their citizens. This manna from heaven severs the link between state and citizens, leading to a range of pathologies from weak and ineffective states to corrupt and predatory ones.

The paradox about India is that despite having been spared nature’s bounty of oil wealth, we still do not have the glue of taxation to make representation more effective and meaningful. Put differently, countries such as Russia, Venezuela, and Nigeria at least have an “excuse” for their low levels of taxation. India does not.

How low are Indian levels of taxation? The telling statistic is the following: Only about 2 percent of the population pays income taxes, resulting in a very small share of personal income taxes to GDP (about 2 percent). And this, after 60 years of having had a flourishing democracy. Is it any wonder that India has fared so poorly on a range of economic and social indicators?

These facts raise some key questions: What explains this low tax and (relatively) low expenditure equilibrium in India? Is it sustainable? And, if not, can and how should it be improved?

Abstract for a moment from the complexities of who really pays for all the taxes (direct and indirect) and who benefits from the resulting government expenditures, and focus on the personal income tax, which is perhaps the most important tax in terms of perceptions of connectedness between the state and its citizens.

For most of the last 60 years, the lion’s share of income taxes was paid by the salaried middle class. So, the fiscal bargain between the state and citizens was one largely involving the middle class. The vast majority of the population, especially the poor, neither paid taxes nor received any significant services.

What did this middle class get though? The state did a reasonable job of providing a few public goods such as law and order; to the extent that a large part of the middle class was employed by the government itself, it also received some services such as health and social insurance; to the extent that this was a privileged urban class, it also received other government-provided services such as power and water; and finally, it was the beneficiary of one invaluable government service: Although urban middle-class parents sent their children predominantly to private schools (the government-run Kendriya Vidyalayas being a notable exception), the state regulated the system of primary and secondary education by setting standards, administering examinations, assessing results, and so on. Indeed, the Central Board of Secondary Education and its state-level counterparts—created by, and working for, urban middle class India—must rank as one of India’s greatest successes as a regulatory institution. (An aside: It is this combination of private provision of secondary education and effective government regulation, as much as the much-touted IITs, IIMs, and medical colleges, that has provided the foundation for the emergence of India as a skilled labor-driven economic powerhouse.)

But this equilibrium—call it the Faustian fiscal bargain between the middle class and the state—is under pressure from a number of directions. First, the quality of even the most basic public goods provided by the state is perceived to be declining (think of the current performance of bureaucracy, judiciary, and police), and even where the government is not completely captured and corrupted, its ability to provide these goods is undermined by the flight of talent to the private sector.

Second, the newly affluent, who have earned their wealth in the private sector, look not to the state but the private sector for most of their services. But above all, the poor, previously left out of the bargain, have reasserted their rights through the political process and are demanding more of the state. They want their rightful seat at the table. The days of the cozy fiscal arrangement between the narrow middle class and the state are probably gone.

In sum, there are three forces at work which threaten the current equilibrium: a demand for greater redistribution by the newly empowered; a demand for better government services from some of the new and old actors; and finally, “exit” by the old middle class and disinterest on the part of the newly rich in response to the perception that the government has not and cannot deliver important services. How should, and will, these conflicting forces be reconciled? Stay tuned for the next column.

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