Now, a ‘wave theory’ of inequality

TCA Ramanujam | Updated on January 20, 2018

Us and them: The divide persists in India - Photo: Prashant Nakwe

No matter what Kuznets, Piketty and Milanovic have to say, India’s rich-poor gap shows no signs of narrowing

Adam Smith, Karl Marx, John Maynard Keynes, please make way. The current debate in the 21st century among economists is not about growth, capital accumulation or business cycles. The focus in today’s economic theory is on growing inequality across the world.

The French economist, Thomas Piketty, burst on the world of economic theory in 2014 with his magnum opus, Capital in the 21st Century. Analysing data from 20 countries in the past three centuries, Piketty showed that we have not modified the deep structures of capital and inequality as much as we had thought in the optimistic decades following World War II.

Fundamental principle

There is a tendency for returns on capital to exceed the rate of economic growth. It threatens to generate extreme inequalities that stir discontent and undermine democratic values.

Analysing the forces of convergence and divergence, he showed the rise in income inequality in the US between 1910 and 2010. He tried to show that the rate of return on capital remains significantly above the growth rate for an extended period of time leading to a high risk of divergence in the distribution of wealth.

He wrote the fundamental principle of inequality as r > g, where r stands for the average rate of return on capital including profits, dividends, interest, rents and other income from capital, expressed as a percentage of its total value, and g stands for the rate of growth of the economy i.e. the annual increase in income or output.

The Kuznets Curve

The president of the American Economic Association, Simon Kuznets, propounded a theory in 1955 trying to show that inequality can be expected to follow a ‘bell curve’. It should first increase and then decrease over the course of industrialisation and economic development.

Inequality automatically decreases as the larger and larger parts of the population partake of the fruits of economic growth.

Thomas Piketty’s model showed those assumptions to be historically untrue. According to him, the more perfect the capital market, the more likely r is to be >g.

Piketty showed that inequality, which was on the wane between 1930 and 1970, has risen sharply back towards the high levels of the industrial revolution. And now comes Branco Milanovic from the City University of New York.

Enter Branco Milanovic

In his latest book, Global Inequality — A New Approach for the Age of Globalization, economist Branco Milanovic has taken on both Piketty and Kuznets. Kuznets had argued that inequality is low at low levels of development, rises during industrialisation, and falls as countries reach economic maturity.

According to Kuznets, high inequality is the temporary side effect of the developmental process.

Piketty suggested that high levels of inequality are the natural state of modern economies. Milanovic explains that both are mistaken.

Inequality, according to him, has tended to flow in cycles, what he describes as “Kuznets waves”. With industrialisation, the Kuznets wave changed: to technology, openness and policy (TOP as he abbreviates it).

As workers were reallocated from farms to factories, from rural to urban areas, average income and inequality soared. Technological progress and trade worked together to squeeze workers. The declining economic power of the workers is compounded by lost political power as the very rich use their fortunes to influence candidates and elections (crony capitalism?).

The prognosis is that world inequality will keep rising. Rich economies today stagnate as they struggle to find places to earn good returns on their piles of wealth.

He predicts that emerging economies will probably continue on their paths. Rising inequality triggers countervailing social dislocations. Can governments avoid a crisis of high inequality?

The Indian context

We all know that the number of millionaires and billionaires has been going up from year to year. Has fiscal policy failed to reduce levels of inequality. If so why?

1. Piketty finds the tax GDP ratio of about 10-15 per cent of national income the main reason . India has had great difficulty moving beyond an equilibrium based on a low level of taxation.

2. Agricultural income is not taxed. There were 2,746 cases showing agricultural income of ₹1 crore and more in the last seven years.

Of these, 1,080 cases were from assessment years 2011-12 to 2013-14. (see BusinessLine of March 15, 2016.)

3. Tax on super rich is a flea bite. Only a surcharge of 15 per cent is levied on incomes above ₹1 crore.

Why not a separate higher tax for the super rich instead of surcharge.?

4. The 10 per cent tax on dividends above ₹10 lakh is a mirage. It should have been at least 25 per cent. In the alternative, profits appropriated towards dividend should be deducted from corporate incomes before levying tax.

This will ensure parity between corporate capital in the form of equity and loan capital which bears interest.

5.The voluntary income declaration scheme is meant to help the super rich.

6. Additional resource mobilisation is concentrated on indirect taxes with a slew of relief in the field of direct taxes.

7. Service tax levy is high. At a time when western countries such as Canada are thinking of reducing VAT, we in India are looking at ways and means of increasing indirect tax rates even while reducing direct tax rates.

Will we ever move towards an egalitarian society which will reduce inequalities in income and wealth?

Woh subah kabhi tho aayegi...(that day will surely dawn).

The writer was chief commissioner of income tax and ex-member of the Income Tax Appellate Tribunal

Published on April 14, 2016

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