[Dec 2007, Volume 4 Quarterly Issue] Pdf File size - The IIPM Think ...

REIMAGINING INDIA
Taxes, Corruption And Structural
Defect
Tax system is a powerful weapon in the
hands of economic policymakers. Tax system
is a major source of funding where
political parties and government planners
collect money and slice a fraction of the
GDP for government spending and consumption.
Currently India levies moderate
tax rates on corporate and individual
income. By 2007, top personal and corporate
income tax rates were 33 percent plus
10 percent surcharge. Other taxes includto
the realization of promises which is oftenly
negatively related to growth prospects
and economic performance. Political
preference for expansionary welfare
state demand greater involvement of government
into the economic structure and
thus political pressures reduce the scope
of growth potentials. Every economic
theory agrees that the long-term engine
of growth is capital creation which means
savings and investment. The share of government
in the economy is equally important.
The following picture known as the
Rahn Curve shows the empirical relationship
between economic growth and government
spending.
Output
performance
RAHN CURVE
Goverment apending
as a share of the GDP
Source: Brimelow (1993), Mitchell (2005)
Picture-1: Rahn Curve
An Empirical Perspective On The
Trade-Off Between Government
Size And Economic Growth
Extensive public sector involves several
macroeconomically important costs. Every
single per unit increase in government
size reduces potential unit of output added
to the gross domestic product. The
costs associated with government spending
are huge. First, government spending
requires the collection of funds of spending.
Costly choices mean an inevitable
adverse consequence such as reducing the
size of investment which is an important
component of the GDP. Second, the effi-
ciency of investment is determined by the
efficiency of allocation of resources. In
this respect, expanded public sector hinders
private sector activities subject to the
fact that resources are scarce; the foremost
basic corner-stone of economics.
Third, government spending supports
backward regulation and intervention,
displacing the competitiveness of product
markets and interfering growth performance.
Phillips and Shen (2003) showed
that the overall impact of a 10 percent decrease
of state-owned enterprises in China
boosted the regional growth of GDP
by 1.14 percent. 5 The case of China shows
that costs involved in government spending
include economically undesirable
choices and decisions. In addition, high
level of government intervention through
regulatory agencies protecting existing
monopoly or oligopoly structures stimulates
market distortions by discouraging
productive behavior. The reason why government
spending is wasteful and burdensome
at some point, as demonstrated by
the Rahn Curve, is that additional spending
empowers the size of government and
also because spending outlays boost the
misallocation of resources due to asymmetric
information.
A valuable lesson for Indian policymakers
is to learn the lessons associated with
government spending from other countries
where decades of output growth and
rising productivity returned a comparatively
high GDP per capita and sound
economic performance and also an experience
with economic setbacks and downturns
caused by the mistakes in economic
policy. Bassanini and Scarpetta (2001)
showed that an increase in one percentage
point in tax pressure – two thirds of what
was observed over the past decade in the
OECD sample – could be associated with
a direct reduction of about 0.3 percent in
output per capita. If the investment effect
is taken into account, the overall reduction
would be 0,6-0.7 percent. 6 Tanzi and
Schuknecht (1996) compared the size of
government and growth performance in
selected industrial countries, concluding
that average 5-year growth was higher in
countries with small governments. The
investigation showed that countries with
small governments observed lower actual
unemployment rate, lower rate of shadow
economy and also exhibited more regulatory
efficiency, higher innovation levels
and a well functioning non-distortionary
labor markets. 7 Another argument in favor
of lower government size and spending
as a core economic reform is the wellobserved
fact that the reduction in public
spending as a share of the GDP is positively
related to the growth of total factor
productivity. Decades of mismanaged
economic policy led to an obscure increase
in the size of state-owned enterprises
carrying out some major deficiencies
and the failure in the allocation of
resources which caused a decline in the
overall competitiveness of the economy.
148 THE IIPM THINK TANK