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Theoretical Basis of the Budget 2005-06

Ever since its presentation to the Lok Sabha, the Central Budget 2005-06 has been continuously dominating public discussion, though many other topics have come and gone. Most media people and their pay masters in trade and industry are euphoric. Tarun Das of CII has termed it as “a dream budget”. The middle class salaried people are busy calculating their gains and losses on the basis of reduction in their tax liabilities and hike in petroleum prices and 0.1 per cent new tax on the withdrawal of Rs 10,000 or more from the bank in a single day. Trade and industry people are happy owing to reductions in corporate income tax and customs. Economists are debating the likely impact of these proposals on economic growth and fiscal deficit.

While UPA constituents are showering praise, the NDA is either ignoring or finding fault with it.

Nobody, however, is trying to discuss the theoretical basis on which the budget is based. It is needless to add that without going into it, it is not possible to grasp its various dimensions and its likely impact on the economy and society. If we look slightly deeper into the budget and Economic Survey 2004-05, we shall see that it is based on ‘the supply-side economics’.

Though the theoretical roots of the supply-side economics may be discerned in the writings of classical economists, it was the French economist Jean-Baptiste Say (1767-1832) that elaborated its various aspects more clearly in his magnum opus Traité d’economie politique (1803), which appeared in English translation in 1880 as A Treatise on Political Economy. He maintained that an economy could be self-regulating if all prices, including wages, were flexible enough to maintain equilibrium. In other words, the government, trade unions and organisations of consumers and producers must be barred from interfering with the working of the market forces. His dictum: “supply creates its own demand” summed up the essence of his theory. He ruled out over- and under-production if forces of supply were allowed to operate without any hindrance.

This dogma ruled unchallenged till the Great Depression (1929-33) plunged the USA and the rest of the world, barring the Soviet Union in an unprecedented crisis. John Maynard Keynes laid bare the weaknesses of Say’s law and its theoretical basis. To quote, “ From the time of Say and Ricardo the classical economists have taught that supply creates its own demand; -- meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product.” (The General Theory of Employment, Interest and Money 1936, p. 18). He demonstrated on the basis of his rigorous analysis that “Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.” (Ibid. p.26)

Keynes demonstrated that there was need for an active intervention by state to ensure that sufficient employment opportunities were created and national income was properly distributed so that there was no shortage of effective demand to clear the market. President Roosevelt based his New Deal on Keynes’s teachings to take out the American economy from the abyss in which it had fallen. Britain and other Western countries too followed his prescription.

For around four and a half decades nobody bothered about Say’s law, but, come 1970s and it was taken out of the dustbin of history, dusted and dressed in new and seemingly attractive clothes to be presented in 1975 by Jude Wanniski, associate editor of The Wall Street Journal during 1972-78. He called it the supply-side economics and elaborated it in his book The Way the World Works (1978). He pleaded for keeping the state’s economic role to the minimum, reducing tax rates as much as possible, curbing trade union activities and so on. Wanniski received strong support from the Nobel laureate Robert Mundell and Chicago University’s Prof. Arthur B. Laffer. About the latter, it was propagated that, while sitting in a restaurant. he drew a curve on a paper napkin demonstrating that there was a clear-cut relation between average tax-rates and total tax revenue. Beyond a certain average rate of tax, total tax revenue would fall because it would adversely affect the incentive to earn and enjoy. Besides, tax evasion would become more attractive. If the tax rate was low, the people would be prompted to work hard so that they could earn as much as possible and after discharging the tax liability they would be left with enough money to enjoy and save. The Laffer curve implied that there was an optimum tax rate that could yield maximum possible tax revenue and this put a ceiling on public goods like health, education and other facilities to be provided by the state. Laffer held that there was no need for indulging in budget deficit and state should keep its activities within limits so that expenditures did not exceed its revenue.

It needs to be noted that, in spite of the myth created about the origin of the Laffer curve, history testifies to the fact that this idea was presented as early as 1844 by French economist Jules Dupuit (1804-66) in 1844.

A powerful and concerted push was given to the supply-side economics. Books and newspaper write-ups began coming in torrents. While Wanniski set up a Supply State University, Victor Canto, a disciple of Laffer came out with The Foundations of Supply-side Economics (1983), focusing on the effects of marginal tax rates on the incentive to work and save, which affected the potential output.

In the 1980s, the supply-side economics had powerful conservative supporters of the free-market system at its back. They demanded cuts not only in the average tax rates but also in social welfare spending by the state. The tax revolt in California in the 1970s and economic difficulties during the Carter administration were used to assert that there was no alternative to the supply-side economics. The supply-side economics became the sheet anchor of economic policies during Reagan administration. Tax rates were cut substantially and “the magic of the market place” was installed as the supreme deity. Although the protagonists of the supply-side economists maintain that tax cuts of the 1980s were responsible for the decade’s high economic growth rate, there are others who argue that tax cuts led to massive federal deficits and the poor and middle class people were made to suffer as the expenditures on the programmes intended for their benefit were drastically reduced.

The supply-side economics came to form the basis of what came to be widely known as Reagonomics. Robert Mundell advised Reagan in 1981 to lap up the Laffer prescription and substantially bring down the tax rates. This would, in turn, induce massive investments, leading to huge increase in production, employment opportunities, income and, ultimately, market would be cleared. Besides, there would be no inflationary pressures as budget deficit would be wiped out and there would be a perfect match between demand and supply. Reagonomics, in essence, consisted of four elements, namely, (1) a restrictive monetary policy designed to stabilise the value of the dollar and contain the runaway inflation, (20 tax cut to the tune of 25 per cent vide The Economic Recovery Tax Act of 1981, designed to encourage savings, investment, work, and economic efficiency, (3) balanced budget through a restraint on domestic spending, and (4) an agenda to roll back government regulations.

Unfortunately, these goals were not realised. David Stockman, budget director during the Reagan administration is on record saying that the “Rosy Scenario” was “cooked”. Nobel laureate Joseph Stiglitz in his book The Roaring Nineties tore the arguments of the supply-siders to pieces. A number of critics called in question the academic credentials of prominent supply-siders like Jude Wanniski and Robert Bartley.

Now, let us return to our budget of 2005-06. During the Lok Sabha election the Congress had raised the slogan: “Congress Ka Hath Aam Adami Ke Sath” and invoked the legacy of Mahatma Gandhi and Pandit Nehru, but this budget which is more loyal to the Washington Consensus and the supply-side economics has made it clear that those who look after the economy do not care a damn for what was said nine months ago. There are two important paragraphs (1.63 and 1.69) in Economic Survey 2004-05 that amply demonstrate it. Since the authors of this document firmly believe in the supply-side economics, they are ready to prostrate before the investors, especially foreign ones and refashion labour laws to suit their needs. Paragraph 1.63 talks of “the issue of simplifying procedures and relaxing entry-exit barriers. The ease with which firms are able to enter into and exit from business activities is an important determinant of the investment climate. For business start-ups, a large number of clearances have to be taken both at the Central and State level. Such a system introduces delays and creates avenues for corruption. Studies show that with a heavy regulatory burden on business, India still ranks in the bottom quartile of comparable nations in the ease of doing business…. Indian labour laws, particularly Chapter VB of the Industrial Disputes Act, 1947, allow firms less latitude … Small-scale reservation has not succeeded in producing the expected results, and has constrained investment in some critical sectors, such as knitwear, with large growth potential. There is little justification for continuance of such reservations….

Easing the entry-exit barriers will be critical…” In a word, let the interests of the toilers be sacrificed to please the prospective investors.

Now, paragraph 1.69. It rules out Gandhi, Nehru, the Karachi Congress resolution and the formulations of the National Planning Committee and the experiences with MNCs during Nehru-Indira Gandhi regimes more particularly with reference to oil sector as totally irrelevant to present-day India. This is being done not on the basis of any resolution of the Indian National Congress after a thorough discussion but because a group of people, loyal to the Fund-Bank line, occupying high echelons in the government, think so. Paragraph 1.69 reads as follows: “… the need for higher investment, in the form of foreign direct investment (FDI) and FII. Such investment triggers technology spillovers, assists human capital formation, contributes to international trade integration and particularly exports, helps create a more competitive business environment, enhances total factor productivity and, more generally, improves the efficiency of resource use. Progressive global integration of the Indian economy has resulted in successful assimilation of many domestic industries in global production chains.” Unmindful of the consequences in terms of unemployment and social unrest, it goes on to stress the urgent need for FDI in retail trade. This, even a man in the street knows, will strengthen the BJP and the RSS. It is strange that this has not occurred to those wise men in power. Moreover, the authors of economic policies are not aware of the recently published book by John Perkins, for a long time an economic hitman for the MNCs. Nor are they bothered about the UN’s annual report World Economic Situation and Prospects 2005” where the Fund-Bank and their approach have been castigated.

Following the supply-side economics, the Finance Minister has brought down the rate of corporate tax from 35 per cent to 30 per cent. The rates of personal taxation have also been modified to bring down the tax liabilities. Customs duties too have been reduced. All these steps have been taken without paying any heed to raising resources to meet obligations and promises to Aam Adami. Andy Mukherjee of Bloomsberg News in his column in International Herald Tribune (March 2, 2005) has termed P. Chidambaram’s budget as “India’s supply-side budget”. His main mission, according to Mukherjee has been “to live up to his reputation as a supply-sider.” In 2005-06, notwithstanding all the rhetoric public investments will be down by 24 per cent as compared to 2004-05. It is a matter of time that disinvestment or, plainly speaking, privatisation will be resumed because the choice posed is that you cannot have both: building irrigation canals and power plants and sinking money into inefficient state enterprises and the business of giving subsidies on one pretext or the other.

Just as this piece is being written Financial Times has come out with a report that the government has decided to allow its 29 States to set up SEZs (special economic zones) where labour laws of the land will not apply and investors will be unhindered in their operation.

Indian economy is going to grow at 7 per cent this year. Last year the growth rate was even higher. How far Aam Adami has benefited is clear from the fact over the past five years, employment opportunities increased by less than one per cent per annum while the size of labour force went up by 2 per cent per annum. Obviously the backlog of unemployment increased even though we do not take into account de-industrialisation that has set in in certain sectors since the beginning of reforms.

Another dimension of the supply-side economics is “trickle-down strategy” of which Montek Singh Ahluwalia has been a committed proponent. This strategy informs economic reforms since 1990s. The paucity of space forces us to postpone a discussion of this strategy to some future date.

Girish Mishra,