Pranab’s tax breaks for higher-income brackets justified

Post the budget, finance minister Pranab Mukherjee was criticised for not changing the tax structure for individuals earning less than Rs 3 lakh a year. But there is no need to lament on this.
We have always had a socialistic bent to our thinking and have been taxing the rich to supposedly prop up the poorer sections of society. This line of thinking is what, in the past, led to rates in excess of 80%. Thankfully, such flawed thinking has given way to a far more pragmatic and equitable taxation structure.

So what is the justification in offering those earning over Rs 3 lakh more tax breaks while offering none for those earning up to Rs 3 lakh? To my mind, there are two:

The tax burden needs to be shared. Currently only 3% of the population is under the tax net. There is a need for those in the lower echelons to pay tax too (at a lower rate) 

Taxing those who earn well is a disincentive — it is, in a sense, a tax for doing well. Serenading those in the lower levels with special incentives and other sops will only continue to keep them in their “ghetto”, and is against the principles of equality

This was the same dilemma that US president Ronald Reagan faced when he came to power in 1981. In 1980, under the administration of Jimmy Carter, the US inflation rate had climbed to 14.8%; the top individual tax rate was 78% and unemployment was 7.4%.

During this period, the US economy was in one of the worst states since the Great Depression of the 1930s. Reagan had to devise a constructive, sound tax and monetary policy to pull the US out of its economic quagmire. He cut income-tax rates for the top personal tax bracket dramatically — they dropped from 70% to 28% in seven years. GDP growth recovered strongly after the 1982 recession and produced five straight quarters of growth averaging 8.5%.

Reagan’s policies were influenced by Arthur Laffer’s model that predicts that excessive tax rates actually reduce potential tax revenues, by lowering the incentive to produce goods. The model also predicts that insufficient tax rates (rates below the optimum level) will lead directly to a reduction in tax revenues.
Consider what a 1996 study by the Cato Institute, a libertarian think tank, found: 

On 8 of 10 key economic variables, the US economy performed better during the Reagan years than during the pre- and post-Reagan years

Real median family income grew $4,000 during the Reagan period after experiencing no growth in pre-Reagan years; it fell almost $1,500 in the post-Reagan years

Interest rates, inflation, and unemployment fell faster under Reagan than they did immediately before or after his presidency

The only economic variable worse in the Reagan period than in both the pre- and post-Reagan years was the savings rate
Like Laffer’s Curve predicts, excessive taxation is counter-productive. Benign taxation rates have been found to increase tax inflows over time, even though there may be a short-term dip. This has been validated in India where tax rates have come down over time and tax revenues have gone up steadily.

The writer is a certified financial planner who runs Ladder 7 Financial Advisories and can be reached at ladder7@gmail.com