Wednesday, April 20, 2011

Cash transfers and negative income tax credits

Cash transfers are the flavour of the season in India. The two commonly discussed cash transfer strategies are direct cash transfers to replace subsidies (as in case of food grains, kerosene, fertilizers, cooking gas etc) and conditional cash transfers to incentivize social outcomes (immunizing, sending children to school, maintaining nutritional standards etc).

In both cases, it is proposed that the cash can be transferred using the Aadhaar identity number to the beneficiary's Aadhaar-linked savings bank account. Though this will not completely resolve the problem of beneficiary selection, the issues of pilferage (by ghost and duplicate beneficiaries) and administration of the transfers will be satisfactorily addressed.

Apart from the two aforementioned types of cash transfers, there is a view, still marginal, that advocates direct payment of cash to all those below the poverty line. Such a universal minimum income guarantee, it is argued, should replace all subsidies and, if delivered through biometrically validated Aadhaar-linked accounts, will simplify program administration, minimize leakages, and limit incentive distortions.

I am not interested in this post to get into the relative merits of the three approaches to cash transfer. Needless to say, there are some very formidable challenges with a universal minimum income guarantee cash transfer. However, if this is adopted, the most effective strategy to implement it would be to package it as a negative income tax (NIT) scheme.

An NIT is reimbursed to the income tax assessee whose income falls below the basic minimum income level for which no one pays income tax. Just as tax payers pay tax at a percentage of their positive taxable income, NIT assessees can be reimbursed, into their Aadhaar-linked accounts, at a percentage of their income deficit (or shortfall from the basic minimum level at which tax kicks-in, the negative taxable income).

Milton Friedman had first proposed the NIT in the late sixties to replace all other welfare programs for the poor. A variant of this, the earned income tax credit (EITC), was introduced in the US in the seventies for the working poor.

The NIT has several benefits in the Indian context. Apart from the numerous benefits arising from dispensing with all other subsidies, the NIT, by making every individual file his income tax returns, would be big step in legitimizing all income streams. Though there will be the risk of people under-reporting incomes, it will open up a large part of the massive parallel economy in India.

The formidable challenge, as mentioned, will be to get people to report their incomes with reasonable degree of accuracy. Rigorous analysis of the massive database so created would itself provide ample information that can further uncover the parallel economy.

In any case, this would be a definite improvement over a direct minimum income transfer where cash would be transferred without any pre-conditions to all the identified beneficiaries. But with NIT, the government would be benchmarking all transfers to the reported incomes of the individual.


Anonymous said...

It could take another 100 years for all the labor force to be able to file taxes or report incomes! Aadhar cards, once issued to all individuals, can help a lot in beneficiary identification but the govt has been half-hearted thus far in rolling out the biometric cards on massive scale. The govt is also half-hearted and fears backlash in linking PAN cards to UID as can be seen that there are no plans underway. Currently, there are 96 million PAN card holders and 34 million tax filers in a population of 1.2 billion. There is tremendous scope for tax compliance and revenue generation for govts if all the citizen services including banking and property registration are linked to UID. The idea is that the poverty stricken bottom one-third of the population can be sufficiently compensated by cash, goods and public infrastructure provisions, once the rest of the two-third are sufficiently taxed. Any thoughts on this?

gulzar said...

i agree that there are problems in its administration.

the post was only meant to highlight that if we did adopt a minimum income guarantee scheme, it was more effective to implement it as a negative income tax credit.