It is always difficult to arrive at the import of the scores of budgetary clauses in the finance minister’s speech each year. How does an engaged citizen decide whether the new allocation and policies are moving us in the right direction? What does an ideal budget look like? I suggest a few basic principles of public finance, found in most elementary textbooks on the subject that are especially helpful answering some of these questions.
The taxes, subsidies, grants and rules of a budget perform two functions. They change the decisions that individuals and firms make by altering the incentives they face. They also raise revenue that allows the state to function and provide those services, which markets cannot efficiently produce and redistribute towards those families that have too little.
The main rationale for changing choices is that individual activities can generate societal costs and benefits that are sometimes quite large. Smoke from industrial plants, large cars on narrow city roads, the burning of litter or open defecation in neighbourhoods are common examples. On the other hand, a good education makes citizens select better leaders, research in universities reduces major diseases and musicians, writers and artists improve the aesthetic content of our lives. In all such cases, taxes and subsidies are valuable regulatory devices even if the state did not need to raise revenue. Taxes should be used to curtail activities that generate external costs and subsidies for those that have external benefits.
When revenue needs remain unmet through these optimal taxes, additional taxes should be imposed on those whose choices they are least likely to distort and on richer households for whom the marginal rupee is less valuable. Regulatory changes or investments in technology that improve governance such as the Aadhar initiative are especially valuable because they reduce waste and lower the future tax burden.
The above principles though commonplace have found very little space in the public justification of budgets put forward by Indian governments in the recent past. Nor do they figure in the political slander that follows their announcement. Using them can however help us evaluate some of the controversial provisions in the current budget.
Enlarging the service tax net and a rise in the rate of service tax and standard excise from 10 to 12 per cent have been widely criticised as against the “common man’’ who must now restrict his use of important services and postpone the purchase of durable goods. If taxes had to be raised, services seem better suited than either manufacturing or agriculture. The growth in services during the past year has been over 9 per cent while the other two sectors have been struggling at under 4 per cent. Unlike both manufacturing and agriculture, many services are non-tradeable and are not in danger of international competition. For those that are, such as ICT related services, I believe that profit margins are high enough for these firms to absorb the extra tax burden. This is clearly not the case for manufacturing, where much will depend on how Indian firms can compare with their counterparts in China and find ways to increase productivity as labour costs rise. Finally, the higher tax is unlikely to affect the poor much as they consume a small share of services in the organised sector. The incidence of higher excise taxes is harder to predict. Since these are largely on durable and semi-durable goods and inputs into them, they will affect rising middle classes, but again, not the very poor. In terms of the principles outlined above, these taxes will raise revenue without significant allocative distortions.
On new expenditures, direct grants to create and strengthen organisations for agricultural research and rural development are very welcome. The agricultural extension system that was created after independence and widely used in the past has decayed and providing funds to these institutions could have large effects on agricultural practices within a few years. These direct grants can serve as important signaling devices that bring about reforms in other institutions like the UGC and state departments of education. The need in the sector is to move away from a uniform set of entitlements and direct resources to areas that need them most and can make good use of them.
On disappointments, there are no substantive proposals on either health or packaging of processed foods, organic farming rather than fertilizer subsidies for conventional methods and a health monitoring scheme in public schools to accompany the mid-day meal scheme. I doubt that any of these initiatives would have been politically controversial environmental problems. These are areas where the external effects are the greatest and existing incentives minimal. Tax-breaks on health check-ups and reduced duties on soya products are a bit of a joke, given the seriousness of the problems in these areas. A little more imagination here may have encouraged recycling, better.
The opinions expressed in this column are the author’s own.