Progressive taxation and user charges for government services

The Union Budget 2011-12 in India had left the marginal tax rates for both income and corporate taxes untouched, much to the applause of private sector and tax payers. This blog has repeatedly laid out the case for higher marginal tax rates on various grounds here, here, here and here.

Classical economics advocates that optimal taxation should be based on the principle of equalizing marginal utility of all members of the society - or taxing at the margins in such a manner that the marginal utility lost from each additional rupee of tax should be same. Translated into English, this meant higher tax rates on those up the income ladder. Opponents point to its perverse incentive effect on effort and the resultant efficiency costs of the tax.

In a very interesting paper early last year, Greg Mankiw had made the philosophical argument that any optimal taxation policy should be based on the premise that people should get the income they deserve - he who "contributes more to society deserves a higher income that reflects those greater contributions". He wrote,

"If we take public attitudes as a gauge of our innate moral intuitions, then in evaluating distributive justice, we should focus not on the marginal utility of different individuals but on the congruence between their contributions and their compensation... it is also a standard result that in a competitive equilibrium, the factors of production are paid the value of their marginal product. That is, each person’s income reflects the value of what he contributed to society’s production of goods and services."

In this world-view, if people are earning their "just deserts", there is no room for a progressive system of taxes and transfers, except in case of externalities (positive and negative) and public goods (national defense, police, the court system etc). This naturally leads to a tax system in which higher income individuals pay more in taxes and poor people are subsidized with transfers. He wrote,

"Surely, those with higher income and greater property benefit more from a governmental system that protects property rights. Moreover, the monetary value attached to other public goods (such as parks and playgrounds) and to positive-externality activities (such as basic research) very likely rises with income as well... What about transfer payments to the poor?... As long as people care about others to some degree, antipoverty programs are a type of public good... we would all like to alleviate poverty. But because we would prefer to have someone else pick up the tab, private charity can’t do the job. Government-run antipoverty programs solve the free-rider problem among the altruistic well-to-do."

This justification for higher taxes by the rich could be interpreted differently to arrive at much the same conclusions. It could be argued that the higher taxes paid by the rich are simply the cumulative user charges for the government services they draw upon to sustain their economic activities. Even a cursory analysis of government expenditures will show that the major share of the expenditures of modern day governments are not on subsidies and welfare. Instead, they are on capital intensive infrastructure investments (highways, ports, airports, power etc), whose marginal benefits are disproportionately higher for the rich than the poor.

In fact, the immediate and direct benefits of all such investments are invariably confined to the rich. The poor and middle class benefit by its trickle-down, lagged and indirect effect. And we all know that such trickles are most often drips that hardly wet the parched populace at the bottom.

In India, the Union Budget allocated Rs 1.25 trillion for defence and Rs 1.21 trillion for the entire social sector. In many respects, national security is the price of an insurance against all forms of uncertainty. In modern societies, such uncertainty impacts the economy, especially its higher echelons, and the economic lives of people who inhabit there. In contrast, the impact of such uncertainty on the economic lives of the poor and even the middle class is marginal.

An episode of Chinese muscle flexing on the Bay of Bengal will impact the financial markets and the prospects of many businesses directly, immediately, and substantively. In contrast, its impact on the vast majority of India's poor and middle class would be indirect and marginal. Principles of efficiency and internalization of costs clearly indicate that the rich should pay more for national defence than the poor. The same logic could be extended to other capital intensive investment areas like most parts of infrastructure sector.