Why is China ahead of India ? A fascinating analysis by Amartya Sen

I had the wonderful opportunity to listen to my former professor Amartya Sen at the World Bank who attempted to answer this very pertinent question in the minds of many today. The fundamental question at the core is why is it that while we rate democracy as the better form of government, it is single party ruled China that has been more successful at bringing more people out of poverty than democratic India? The implications for India are clear; investing in education and health for all its citizens is the best solution for long term growth.

Professor Sen argues that it is not the nature of government that is the main factor in China’s success but its investment in health and education that provided fuel to its explosive growth. India he said has under-invested in these key areas and hence its economic growth is poorly supported by quality human capital. Professor Sen was critical of the suggestion that countries could grow economically first and then invest in education later saying that it was the reverse that is true. He supported his claim bringing historical evidence of Japan’s rapid growth since  the

second decade of the 20st century being driven by its investment in health and education after the Meiji restoration on the 1868. More recently, similar investment by Korea and the South East Asian countries provided impetus to economic growth in these countries.   I wanted to see the evidence first hand and looked at the data.

In the case of India, while efforts have been made to improve literacy, its literacy rate in 2011 is 74% well below China’s at 95% (in 2010). In fact India’s literacy level today is even less than what China’s was in 1990 (figure-1).

The case of health is no different. In the case of life expectancy, once again India’s life expectancy in 2011 is below what it was in China’s in 1990 (fig-2).  Today India’s life expectancy is 11 years below that of China.

These data supports Amartya Sen’s basic premise that India’s low literacy rates and poor health outcomes as compared to China’s may explain a big part of the disparity in development between the two countries.   You can see the entire talk on the World Bank website http://live.worldbank.org/china-ahead-india-amartya-sen. The message for policy makers to India is clear. There are no

short cuts to development and that one cannot grow without strengthening the capabilities of each  and every citizen how-so-ever poor they may be or where ever they may live however remote. Economic growth needs strong foundations which India currently lacks.

Interestingly, another of Harvard’s economists Dani Rodrik has a different take on this issue which he has explained on his blog, but that is a discussion for another day.

Why a Flat Income Tax is an Oxymoron?

As the debate on Flat taxes in the US gets louder, one thing that is lost in the debate is the very purpose of a tax system which consists of multiple taxes levied on different tax bases.

The principal taxes in the US are the Sales Tax, the Income Tax and the Property Tax. While each of these taxes provide revenue, each of them play a different role. The Sales Tax and the VAT are essentially taxes on consumption and are revenue generating instruments. The Corporate Income Tax like the Sales Tax and VAT serve a primary purpose of generating revenue. The Property Tax is primarily used to pay for local public goods such as schools and the police. The Personal Income Tax on the other hand is an important tool promoting equity apart from its revenue purpose. No other tax is so suited to promote equity. The primary mechanism as to how a Personal Income Tax does this is through progressive tax rates with higher incomes attracting higher tax rates and lower incomes either having a lower tax rate or exempt from tax or some even receiving a payment from the government such as in the case of an Earned Income Tax Credit (EITC). For a detailed discussion of this, see section 4.1 in the chapter on Simplifying Tax Policy in the Handbook of Tax Simplification that I authored http://documents.worldbank.org/curated/en/317341468335679099/A-handbook-for-tax-simplification.

Policy makers sometimes confuse these purposes. Take the example of the VAT or Sales Tax. Some countries levy different rates for different goods with the aim of introducing equity into the tax. The VAT or the retail Sales Tax is a broad based tax on consumption and is an excellent instrument to generate revenue. Trying to introduce equity into this tax only reduces the ability of this tax to work properly creating opportunities for tax leakage and making its administration difficult. For example, goods that are typically consumed by the poor are levied Sales Tax or VAT tax at a lower rate. Basic food items such as rice and bread typically attract a zero rate. While this makes for good optics, such an exemption also benefits the rich who also consume these basic food items and typically in larger quantities. While it is not equitable, exempting it from the tax for the purpose of equity leads to loss of revenue, revenue that could be used to fund the government programs that could be better directed to the poor.

In this regard a flat personal income tax which replaces the progressive tax rates with a single tax rate that applies to all taxpayers strips out the equity aspect of the tax for which it is primarily designed. Most of the supporters justify this in the name of simplification, but the progressivity of a tax system is the least problematic part of the complexity of the tax system.

The US curiously has a progressive corporate income tax. The idea of introducing equity among corporations that are legal entities through higher tax rates for higher corporate profits is without a strong basis. A flat tax among coporations has another dimension. Corporate Income Tax typically has several tax exemptions that encourage certain activities. These make the effective tax rates of different corporations widely different depending on the number of exemptions they are eligible to. Flattening the Corporate Income Tax typically involves removing many of these exemptions to replace the complex system with one that is simple and imples nearly similar effective tax rates for all corporations.

So what can we take out of the the Flat tax debate ? That while trying to come up with a Flat Corporate Income Tax makes sense, doing the same for Personal Income Tax is a bad idea.

(Disclaimer: The views expressed in this blog are personal and should not be attributed to the World Bank Group)

Tax Policy and Inequality

Inequality of wealth is a growing problem in the world today. The disproportionate amount of wealth owned by the top 1% as compared to the remaining 99% is the main theme of protests around the world starting with the Occupy Wall Street protest and the subsequent movement to occupy different financial centers around the world. The United States Congressional Budget Office reported recently that the income of the wealthiest 1% in the US grew by 275% between 1979 and 2007 while that of the bottom 20% of the US population it only grew by 18%. In urban China, the rise in the Gini Coefficient (an indicator of inequality with 100% being most unequal and 0% being most equal) increased by 9% points since 1990 while in urban India it went up by 3% points. The number of millionaire households in China is now about a million and about 200,000 in India both of which are expected to rise significantly.

Excessive concentration of wealth is not good for a stable society and for sustained growth as this reduces the opportunities for those not so well off to do better for themselves economically. Those in posession of huge amount of wealth may also rig the system to maintain the status quo by using their money power in different ways. The rising inequality and the ensuing protests indicate that something must be done about it and that the existing tools are ineffective or used ineffectively.

The rising inequality in the case of India and China indicate economic growth that would first benefit the rich who have access to capital. However it also indicates that Fiscal Policy (Tax Policy and Expenditure Policy) tools need to be used to moderate inequality in these two countries.

The Kuznets curve formulated by Nobel Prize winning economist Simon Kuznets in the 1950s tried to explain rising inequality during early phases of economic growth and its fall on further development. The inverted shaped U curve shows a high inequality for countries with in the middle of development as indicated by the per-capita income while lower for poor countries and rich countries. There are several explanations offered to the shape of the curve. Kuznets himself suggested that rising inequality during the initial phases of economic development is explained by a move from an agriculture based economy to one based on industries. In fully developed economies, most of the population own either physical or human capital thereby reducing the inequality in income.

This explains India's and China's rising inequality. However, the rising inequality in the United States, indicate a serious problem with this hypothesis. The problem can be explained by a broken Fiscal policy that is not allowing the benefits of economic growth to spread to all.

The richest Americans have a lower effective tax rate of 17% as compared to the middle class and even the poor who pay tax at an effective rate of 22.5%. Since 1992, the tax rates for the rich has decreased ten times as the middle class or the poor. The lower tax rates are based on the principle that lower taxes encourage growth which then creates jobs and better economic conditions for the poor. However, evidence of such a trickle down effect is rather to the contrary.

Tax revenue as a result of tax cuts have only resulted in falling revenues and with a weak economy, average wages have actually dropped 6.5% from 2000 to 2009 (so much for trickle down). This indicates that tax rates are too low and the US is on the left hand side of the Laffer Curve where lower tax rates imply lower revenues.

There is also the issue of tax compliance. Corporations (and as a result the share holders) are paying much lower taxes as income is moved outside the country to low tax jurisdictions to avoid paying taxes in the US. There have also been several cases of individuals illegally parking their incomes abroad without paying taxes due in the US. Owners of capital in the US never had it better. They enjoy the benefits of lower taxes on their personal income even while their wealth (due to their shareholding in corporations) accumulate in low tax jurisdictions. The trickle down is not happening. It is said that $1 trillion of profits of US corporations is being held overseas.

One sees shades of the same in India with recent proof of large amount of funds that have escaped tax being stashed in tax havens. The rising incomes in India in presence of international tax evasion does not bode well for the future. The G20 countries have given top priority to combating international tax evasion through greater transparency. However, this does not tackle tax avoidance which is legal. This can only be tackled through better laws, stronger tax compliance and stringent punishment for tax evaders.

Surely Tax Policy is facing its toughest test in becoming an effective tool for governments to reduce inequality.

(Disclaimer: The views expressed in this blog are personal and should not be attributed to the World Bank Group)