America is discussing raising taxes for the rich. Should India consider this too?

American politics is in ferment. In a country where any notion of socialism has long been an anathema to the mainstream, a rising section of politicians is making waves by presenting a progressive vision grounded in socialism. Most visibly by Alexandria Ocasio-Cortez, the youngest woman ever in the US Congress and a self-described socialist.

In a January 4 interview, she proposed to do away with a cornerstone of the United States fiscal policy for decades: low taxes for the rich. The Congresswoman sought a 70% tax rate for those earning above $10 million, or approximately Rs 70 crore.

It sparked a furious debate. The Right piled on the scorn while the Left rallied around the proposal. Yet, there is now growing consensus that “trickle down economics” – the idea that taxing the rich less leads to more spending and, thereby, greater prosperity for everyone – does not work in the real world. The Nobel-winning economist Paul Krugman wrote a defence of Ocasio-Cortez’s proposal, quoting the work of another Nobel laureate, Peter Diamond, whose research puts the optimal top tax rate at 73%.

Is there anything that India can learn from this debate?

Socialist pattern

Independent India inherited low personal income tax from the British Raj. But it increased sharply as socialist ideas took root. Also helping the trend along was a strong central government – in India, unlike the United States, income tax is not collected by states.

Income tax rates peaked in 1973-’74, with the highest income slab taxed at an incredible 97.75%.

In the 1980s, though, liberal economic ideas as well as more prosaic worries about widespread tax evasion pushed for lower rates. In 1985-’86, Rajiv Gandhi’s finance minister VP Singh made significant changes to the income tax regime, cutting the top rate from 62% to 50%.

Liberal turn

In 1991, two years after the fall of the Berlin Wall and barely months before the collapse of the Soviet Union, India started to liberalise its economy. The socialist ideals that had driven high tax rates were now firmly on their way out. In 1992-’93, Finance Minister Manmohan Singh produced a budget with just three income tax slabs and the top rate of 40%. In 1997-98, P Chidambaram reduced the top rate to 30%.

If high taxes made India an outlier in the 1970s, liberal reforms of the 1990s brought about a sharp correction. According to a 2015 report by the auditor KPMG, while the global average income tax was 31.53%, it was 33.99% in India.

Tax failures

As India corrected tax rates that were too high, however, it may have swung too far the other way. As has been frequently pointed out, India has a very low tax to gross domestic product ratio. Praveen Chakravarty and Vivek Dehejia note that India’s tax to GDP ratio was 17.2% in 2013 as compared to 33% for countries in the Organisation for Economic Cooperation and Development.

The post-1991 liberal economic policies seem to have worsened the situation. From 1965 to 1990, tax to GDP ratio increased from 10% to 16%, Chakravarty and Dahejia point out. From 1991 to 2014, the ratio was more or less stagnant, hovering around 16%-17%.

More worryingly, India’s direct tax collections are low, adding up to only 35% of the total tax revenue. That figure is 67% for the Organisation for Economic Cooperation and Development countries. Generally, economists prefer direct taxes like income tax over indirect taxes like the Goods and Services Tax given they are more efficient and fair, taking more from the rich than the poor.

It seems then that India could do well following the US debate on raising income taxes.

However, unlike the US, India’s problems might be graver than simply low tax rates. The country has been unable to develop a manufacturing sector which could provide mass employment. As a result, the economists Thomas Piketty and Nancy Qian write, “The proportion of formal wage earners in the labour force is ridiculously low.” In contrast with India, Piketty and Qian note, China has been able to convert income tax from an elite to a mass tax. The result? India had a larger percentage of income tax payers than China until 1993. But while China’s numbers have shot up since, India’s have stagnated.