India Swings on the Laffer Curve
Jude Wanniski
March 9, 2005


Memo To: Website Fans, Browsers, Clients
From: Jude Wanniski
Re: Finally, Supply-Siders in India

Earlier this week, I wrote this celebration of India's embrace of the Laffer Curve, via its Finance Minister P Chidambaram, for Aljazeera'sEnglish-language website. Over the last 25 years, I've drawn the Curve for everyone I've ever met from India and told the story of how close they came in 1976 to getting on a rapid growth track. It's clear now that someone showed the Curve to Chidambaram and he has been acting on it, cutting tax rates where they are unnecessarily high, generating rapid growth and the revenues that flow from them. I've been drawing the Curve for my Democratic friends over the same span of time and they still don't get it. JW]

By Jude Wanniski
Aljazeera March 7

The one billion plus people of India constitute the largest democracy in the world, but it also has more people living in poverty than any other country.

It has always been so, for centuries at least, but in the last few years it has suddenly broken out of its deep sleep and is now on the move.

Its economy is growing at a rapid rate, the Mumbai stock market is performing well, tax revenues are flowing steadily into New Delhi, and the government is now planning to compete with Beijing in contracting for oil supplies to feed India's growing appetite for energy.

How did this most unexpected rags-to-riches story come about?

One clear reason can be found in a headline in Bloomberg's financial network on 11 January 2005, over a story by Andy Mukherjee writing from Singapore:

"India's Tax Plan May Again Bet on Laffer Curve."

I was most pleased to read that Finance Minister P Chidambaram is hinting at a "massive" change in the country's tax system, slashing tax rates on personal and corporate incomes in a second gamble on "the Laffer Curve", which Chidambaram mentions by name as an idea he has embraced with enthusiasm.

It is the concept that there is a law of diminishing returns on taxation, an ancient idea that Ronald Reagan traced back to Ibn Khaldun, the great political philosopher of the 14th century.

It was an American economist named Arthur Laffer who revived it 30 years ago, drawing a curve that bent back upon itself to show that higher rates of tax could discourage production and reduce tax revenues. This meant that lowering tax rates at that point could increase production and yield greater tax revenues.

On 4 December 1974, I happened to be present when Dr Laffer drew the curve on a napkin for Dick Cheney, who was then White House deputy chief of staff in the administration of Gerald R Ford. It so impressed me with its logic and simplicity that I popularised the idea and named it "the Laffer Curve" in my 1978 book, "The Way the World Works: How Economies Fail - and Succeed."

The concept became the foundation for president Reagan's supply-side tax cuts in 1981 and 1985 that brought top rates on personal income to 28% from 70% in 1980, and slowly but surely countries around the world are experimenting with it - the former communist countries of Russia and Eastern Europe, the People's Republic of China, and most notably India and the other countries of the Asian subcontinent.

When the Swedish economist Gunnar Myrdal began his Inquiry Into the Poverty of Nations in 1957, India was at the top of his list. A decade later he produced "Asian Drama," a three- volume study of 2284 pages.

He was awarded the Nobel Prize in 1974 in recognition of this contribution. The only problem was that Myrdal came to exactly the wrong conclusion, arguing that India had failed to sufficiently tax its people.

Actually, he did acknowledge that upon achieving independence from British colonial rule in 1947, India enacted steeply progressive personal income taxes on its people on the advice of British economist Nicholas Kaldor.

Although there are only a few references to taxation in Myrdal's Asian Drama, when I read the book in 1969 I wondered about the following paragraph:

"Modern income taxation had been introduced in South Asia in colonial times, mainly so that citizens of the metropolitan countries doing business in the colonies should not enjoy an unduly favourable position compared with their compatriots at home; other foreign or indigenous businessmen were taxed to prevent them from having an 'unfair advantage' competitive advantage.

In the independence era, tax rates have been raised considerably, with the result that now marginal rates in the highest brackets tend to be as high as, or higher than, those in the Western countries, although they are not effective ..."

In my 1978 book that first unveiled the Laffer Curve, I went back to this paragraph to explain how Myrdal had the essence of Third World poverty in two sentences, but did not realise it. Here is how I put it:

"If tax rates are kept high in the colonies, they will be kept uncompetitive in manufactures, for industry must reward the skills of the industrial entrepreneur with high income. The colony is thereby kept in a pastoral condition ... . They must remain suppliers of raw materials.

"Yet upon achieving independence, the young political leaders of the fledgling nations ask the former colonial masters what they must do to prove themselves as capable of self-government, and the answer comes back: You must learn to tax yourselves more heavily, for in taxation lies prosperity."

Myrdal, though, explained the tax rates were not "effective" because the four countries of the subcontinent had imposed high tax rates, but their governments had not cracked down on tax cheats, thus their revenues were a low percentage of national output!

In the year Myrdal accepted the Nobel Prize, the highest marginal tax rate in India, encountered at an income threshold the equivalent of $25,000, was 97.5%. The rates were similarly confiscatory in Pakistan, Sri Lanka and Bangladesh. The old colonial masters smiled.

The first break from this pernicious advice came in India in 1975, when poverty became severe as the rupee followed the inflation that struck the world economy when the United States left the gold standard in 1971.

India's work force was pushed into the confiscatory tax brackets and the distress was so great that civil disorder ensued. In March 1975, prime minister Indira Gandhi suspended democratic rule and civil liberties, reflecting Myrdal's call for "hard" government.

With parliament suspended, C Subramaniam, Gandhi's finance minister, saw an opportunity to have Gandhi escape the grip of that colonial advice by dictate. In my book, I explained that Subramaniam used the suspension of parliamentary activity to put through a pet idea.

Not only was the 12.5% surtax removed, but the top rates were cut to 77% from 85% The wealth tax, which had been 8% annually on assets of about $2 million, was slashed to 2.5%, and an urban-property wealth tax, which ranged from 5% to 7% annually, was abolished entirely.

I tell the rest of the story of how revenues boomed so much that Subramaniam came back for a second "whack" at the tax code, cutting the top rate to 66% and slashing income thresholds all the way down the line. Gandhi became popular as the economy expanded and inflation subsided - with the expansion increasing the demand for rupees.

She called elections, thinking she would win easily. But instead of campaigning on the tax reforms, she asked the people of India to approve her suspension of civil liberties.

She and the rest of her cabinet, except Subramaniam, lost the subsequent parliamentary elections and her Congrees Party thrown out of office. It was noted, later, that she had planned to ask the Congress to lower the tax rates again after her election, but, by then, it was too late.

It has taken India 30 years to get back on that track. In his first term as finance minister, Chidambaram experimented with the Laffer Curve and for every 10% reduction in direct income levies, revenues rose 14%, rising seven-fold between 1991 and 2001.

Back in power last year, he abolished long term capital gains and cut the tax on short-term capital gains by one half. Mukherjee's 1 March Bloomberg column, "India's Supply-Side Budget Is a Wake-up Call" confirmed that Chidambaram, who pushed through cuts to the corporate tax in the latest budget, will continue to bet on the supply side. A direction suggested earlier in the 11 January report:

"A clue to how Chidambaram may be evaluating the risks can be found in a speech he made in parliament in 1998 when Yashwant Sinha who succeeded him as finance minister was imposing new taxes, undoing some of his predecessor's efforts.

"'There's a Newton's law of economics: 'For every economist, there is an equal and opposite economist,' Chidambaram said, adding that Sinha 'should not be carried away by what economists will tell him, that the Laffer Curve won't work. The Laffer Curve will work. In fact, he'll reap the benefit of the Laffer Curve'."

So, we hope, will the billion plus people of India, at long last.

Jude Wanniski is a former associate editor of The Wall Street Journal, expert on supply-side economics and founder of Polyconomics, which helps to interpret the impact of political events on financial markets.

The opinions expressed here are the author's and do not necessarily reflect the editorial position or have the endorsement of Aljazeera

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