The Hindu Business Line : Middle-class is not necessarily the decisive voter

EMPLOYERS are busy giving away Form 16s to their hapless staff who shed a tear or two on how much they had paid the previous year, and then save the big sheet for filing with the return.

If any talk of taxes brings a bitter taste to the mouth, how about avoiding? For most people, much time is spent in exploring avenues that offer tax-saving, though if one were to do a cost-benefit analysis, the saving would seem far from worthwhile.

"Political economics of not paying taxes" is a recent working paper from the London School of Economics is by Jesper Roine. It considers "redistributive as well as political consequences of tax avoidance" and goes to state that if tax avoidance technology were more effective, "the equilibrium outcome can change to a situation characterised by a coalition of poor and the very richest favouring a higher tax rate".

That excerpt from the paper's abstract could be abstract for now, but the paper cites interesting statistics of tax avoidance. In Denmark and Sweden, 4 to 6 per cent of total income is avoided (and that is 2 to 4 per cent of GDP); in the US, about 20 per cent of taxes owed are not paid (equal to approximately 2 per cent of GDP); and in Germany, 34 per cent of tax is not paid, corresponding to about 7 per cent of GDP.

How about India? Perhaps the FM has the figures.

Individuals face two decisions, says the author. First, they have to decide whom to vote for in the elections; second, before taxes are paid, individuals decide whether to invest in tax avoidance.

While the former depends on the candidates' views on tax rates, the latter would factor in the tax avoidance `technology'. Tax avoidance could be cheap and inefficient (`standard' tax planning); or expensive and efficient (`advanced' tax avoidance), requiring a CA to counsel.

When avoidance possibilities are limited, the equilibrium tax rate is typically high, states the paper. High-income earners would prefer lower taxes, and low-income earners favour higher taxes. If, on the other hand, tax avoidance becomes less expensive, the equilibrium tax rate goes down. Where taxes can be completely avoided (ah, how idealistic), there is an `unusual coalition', and here lies the problem.

The poor would favour an increase of tax rates because their income is low and so exempt, and the rich too would toe the same line because their taxable income is zero, due to their tax avoidance investments. A rare instance of the two seeing eye to eye. The paper suggests that the very richest section of the population will always invest in tax avoidance.

So, everyone above a critical income level will pay a smaller share of their income in taxes compared to the rest of the population, even if the official tax rate is proportional. Also, tax avoidance possibilities create a trade-off between taxation and the tax base.

"Increasing the tax rate leads, on the one hand, to larger tax payments from those who pay the tax but, on the other hand, it also induces a larger share of the population to invest in tax avoidance and, hence, decreases the tax base."

Our netas might be interested in knowing what the potential political effects of tax avoidance are.

In what could shatter the myth of the middle-class, Roine observes that the median income earner is not necessarily the decisive voter, because of the `coalition' between the rich and the poor, which may favour an increase of the tax rate. End result would be a tax rate that is higher than that preferred by the median income earner.

"Such a situation can be described as an inverse of Director's law, with redistribution going from the middle towards the ends of the income distribution," concludes the paper.

"Allowing for a broader interpretation of tax avoidance, the investments made by the rich could also be seen as political contributions in exchange for `tailored tax cuts', creating an endogenous wealth-biased political mechanism."

A bane the Indian tax regime too suffers from. Far from achieving redistribution of wealth, one of the supposed goals of fiscal policy, a plethora of concessions may actually work in a counter direction, making the rich richer, even as a confused middle-class scurries about aimlessly in search of avenues to reduce tax burden.

hindubusinessline@hotmail.com

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Middle-class is not necessarily the decisive voter