Why we shouldn't always trust economists?

Because their prescriptions are quite often not in touch with ground realities.

One of the key prescriptions that has come from none other than the Nobel Laurette Abhijeet Banerjee is to tax the rich more. The supporters of tax increase argue that India’s income tax rates could be raised further** to increase spending on education and health. That will help improve quality of human capital, and in turn, will lead to increased productivity. There is nothing wrong about it. 

However, the top income tax rate along with surcharge is already 42.7%. Further increasing it in a country like India with poor tax compliance is like penalising those who pay taxes honestly, and inducing others to hide income and dodge taxes. While, the need is to expand the country’s tax base. Worse, it may prompt*** super-rich to migrate to tax havens. That will impact India’s overall savings, and in turn its ability to invest, as rich people have a higher marginal propensity to save.

Another expert prescribes increase in wages through minimum wage legislations to boost demand while forgetting if wages are raised in a slowing economy, businesses will respond by cutting jobs to rein in wage bills and protect margins. Besides, states will be tempted to outbid each-other in raising minimum wages to appease workers, a major voters group. This prescription may work in a country where employment is at all-time high and economic growth comfortable. But in a slowing economy where unemployment is 45-year high, it’ll backfire.

Similarly, India’s former chief economic advisor is advising against  cuttting personal income taxes or any fiscal stimulus as that will increase government debt. The fiscal fundamentalists like him argue that increase in government debt would shrink the net availability of capital and crowd out private investment. There are two flaws in this argument. First, India’s government debt is not too high and it’s an emergency situation as Indian economy is slipping into recession. Secondly, the private sector is not investing and hence it’s not looking for funds. India’s largest state-owned bank’s chairman says that he has enough funds to lend but there are not enough borrowers. That’s why credit demand from Indian corporate sector remains muted. Thus, crowding out argument doesn’t hold. 

There are others from our banking and financial sector who almost always recommend cuts (and never raising them) in interest rates that are already substantially reduced and yet private investment remains muted. It will not revive unless consumer demand. revives. Interest rate cuts often hurt consumer demand through negative wealth effect, in a country where bank deposit remains the major instrument of financial savings. Lower interest rates, on the other hand, aid asset price bubbles and encourage share buybacks that doesn’t create new capital assets or jobs.

There’s already a disconnect between India’s macroeconomic fundamentals and performances of its stock markets that needs to be reined in to protect retail investors who have joined the party late.

To be fair to we economists, we’re not at the top of unrealism chart…Indian bureaucrats are far ahead us. Otherwise, how one could explain the following actions of our babus: 

• A labour ministry advisory says companies including private ones shouldn’t reduce wages or fire workers if they can’t come to office or work from home. It doesn’t matter if money has stopped coming to the companies due to corona-induced lockdown
• Tenants shouldn’t be forced to pay rents
• But businesses and individuals should continue paying taxes.

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For more on Indian babus, you may refer one of my old posts: 13 unwritten rules that guide Indian bureaucracy 

If you like this post, please share it with your colleagues and friends who may like to check it. Please feel free to share your thoughts and views even if they differ from mine. You can get in touch with me on Twitter @RiteshEconomist

A slightly modified version of this post was first published by Nikkei Asian Review from Nikkei-Financial Times here

In case you like the above post, please do read this as well...it's better than mine: The rules of being a sell side economist

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**As income tax rates in India are lower than say, those in Scandinavian countries.

***This populist idea (of taxing the rich more) is quite appealing in a country where roughly one-fifth of population is below poverty line and income inequality is rising as can be seen from rising shares of rich in India’s GDP. Worse, there’s a widespread perception among common Indian folks that rich people frequently dodge taxes and not without reasons. To make matters worse, the Modi government has added fuel to this sentiment for justifying its ill-advised demonetisation and draconian tax measures.