The Hindu Business Line : Fringe benefit and the multiplier effect

Taxing fringe benefits may offer immediate small gains but larger losses later on. Taxing such benefits is to lose sight of the cascading effect of perquisites. Citing Keynes' important concept of multiplier, P. V. Indiresan says that if the Government wants to maximise revenue and growth, and minimise poverty, it should encourage perquisites, not discourage them by additional taxation.

THE controversy over the proposal to tax the fringe benefits of employees refuses to go away. The Government sees in perquisites the shades of fatted lamb; critics find in the proposal shades of discredited socialism which, in their opinion, ought to be buried once for all. They are also perturbed by the complexities of calculating the value of the benefits. The debate need not, and should not, be bogged down in that manner in ideology. It should be analysed rationally. Here is truly a topic suitable for a Ph.D. thesis: Will the tax on fringe benefits fulfil the objectives of the Budget, or are there better alternatives?

The Finance Ministry has three main objectives: (a) maximise revenue, (b) maximise growth, and (c) minimise poverty. In the case of perquisites, assuming they amount to Rs 1000, the government has three options: (a) leave the entire thousand rupee worth of perquisites free in the hands of the receiver; (b) tax it, so that the receiver gets (in round figures) Rs 750 and the government gets Rs 250; or (c) let the perquisites go tax free but print Rs 250 worth of crisp brand new notes at the Nashik Press. Which of these three options will fulfil best the government's objectives?

Partisans on either side may argue that these problems have already been analysed threadbare and there is nothing more to be said. That is not quite correct: In several respects, economics is like architecture. The principles of architecture are well known but every time a new building is proposed, it has to be designed afresh. Likewise, in economics too, every problem is coloured so much by the prevailing state of affairs, that economic policy has to be designed afresh to suit each occasion.

Here is a fit case for the application of Keynes's important concept of multiplier: Any increase in the income of one individual gets circulated several times round the economy leading ultimately to a growth that is several times larger than the original increase. In short, the original windfall gets multiplied. Keynes explained this phenomenon by introducing the concept of Marginal Propensity of Consumption (MPC) and its counterpart, Marginal Propensity to Save (MPS).

Suppose individuals save one-fifth of the extra income they get and spend the remaining fourth-fifths. Then, an individual whose wage is Rs 5000 spends Rs 4000 and saves the remaining. This expenditure becomes an extra income of Rs 4000 for somebody else. Of this extra income, another four-fifths, or Rs 3200, will be spent, which in turn becomes a new income for a third person, who in turn will spend another four-fifths, or Rs 2560, and so on (Table 1). Simple high school arithmetic will show that, ultimately, the economy will be enriched by an overall increase of Rs 25000 — five times the original increase of Rs 5000. The multiplier is five.

In the example given, we chose four-fifths as the MPC and the balance one-fifth as the MPS. That resulted in a multiplier of five — the inverse of MPS. Had the MPS had been one-fourth, the multiplier would have been four; had it been one-tenth, the multiplier would have been ten.

On this argument, Keynes exhorted people to spend like mad. He suggested that if people are not spending enough, the government should, by printing notes and increasing the fiscal deficit. Not many people are aware that all payments in kind, like fringe benefits and perquisites, work in identically the same manner as the fiscal deficit. We may appreciate how by taking a simple example with two choices: (a) the wage is Rs 5000 with no perquisites and (b) the wage partly in perquisites and partly in cash but the total is the same. As Table 2 shows, payment by perquisites enhances growth — the higher the share of perquisites, the greater the multiplier effect. Hence, if growth is the only (or even the main) objective, the government should be encouraging perquisites, not discouraging them by additional taxation.

Apart from promoting growth, the government is interested in revenue too. Will fringe benefits and perquisites increase or decrease revenue? That depends on how long the government is willing to wait. The government definitely forgoes revenue when it does not tax fringe benefits and perquisites. However, what it loses directly by foregoing the tax it makes up by increase in revenues that result from higher growth. In initial years, depending on the share of perquisites and the nature of the tax regime, a net loss is to be expected. But as years pass by, with higher growth rate, tax revenues will rise faster and exponentially too. Just as a faster car will ultimately overtake a slower one — however farther behind it starts — faster growth implies that, ultimately, revenues too will become higher when perquisites are not taxed.

Poverty alleviation is the third objective. How far payment by perquisites reduce poverty is difficult to estimate. If the perquisite is a holiday abroad, the money spent goes to promote the economy of some other country. That country may then buy more from us — order more software from Bangalore. That will boost Bangalore's economy but not that of poor Bastar. It will also make software engineers more prosperous but not the landless labourers.

A revenue increase too may not help the poor much. If the tax goes to the Consolidated Fund, only about ten per cent will go towards poverty alleviation. Of that ten per cent, only a small fraction may actually reach the poor. In contrast, even if the perquisite is a holiday abroad, and directly boosts the income of a software engineer in Bangalore, that engineer may use that increased income to hire a domestic help from a poor village — and help the poor better than the government does. On balance, other things being equal, the poor will benefit more when perquisites are in the form of labour intensive goods and services.

According to newspaper reports, a plot of land in the restricted Lutyens Zone of New Delhi recently changed hands at Rs 300,000 a square metre. Nobody would have risked such large sums without strong assurances that zoning restrictions will be removed. Those who promote such moves are the worst enemies of the poor. If such a basic amenity as land is priced so high, what can the poor do? It is unlikely that the government would have earned much revenue from this transaction. Unfortunately, real-estate developers are so powerful that nobody, not even the Left, can check them. That is perhaps why business expenses have been chosen as the example of "capitalist" extravagance.

When computers were first programmed to play chess, they were made to accept the sacrifice of any chess piece. As a result, they would happily accept the gambit that offered a pawn and lose the Queen soon after. Quite often, our national policies operate in the same way: Prefer immediate small gain even when that entails much larger losses later on.

(This is 146th in the Vision 2020 series. The previous article was published on March 21.)

(The author is a former Director of IIT Madras. Response may be sent to indresan@vsnl.com)

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