The Distributive Aspects of Taxation
This blogpost forms the first part of our series on Money, Debt and Taxes.
The common view on taxation is an informal mix of opinions from political and economic discourse. When these opinions lack rigour, they imperil an informed evaluation of government tax policy and legislative measures, both for the individual as well as the collective. The following conceptions on taxation will be addressed in this blog.
1. Taxes are necessary for public spending; it is the government’s responsibility to incur such spending ‘efficiently’ in order to minimise waste and public debt.
2. Tax obligations are based on the ‘ability to pay’ principle; along with income, consumption is equally an indicator of the ability to pay.
3. Persons falling within high-income groups earn and spend more than low-income earners. As a result, they pay more income tax as well as GST.
4. Where income is being taxed, capital tax should not be imposed – it results in double taxation and discourages investment. Such a high tax burden is distortionary, re-distributive and/ or confiscatory in nature and increases the incentive to avoid tax liability.
5. Tariffs are a fair and effective means of economic policy. They can replace income tax as a source of revenue. Tariffs are not regressive and do not lead to an increase in consumer prices – as their burden is borne by the exporting countries.
A Comprehensive Understanding of Statement 1
Public Spending
The conventional sources for public spending in market-based economies are revenue (tax and others) and borrowings. Tax revenue is the major source of income for most countries; and any borrowings incurred will, therefore, normally need to be accounted for by way of taxes [1]. Countries which earn significant revenue from oil and natural gas exports are notable exceptions; some Gulf Council Countries like Saudi Arabia and UAE impose low taxes. The other classification of exceptions are tax havens that offer nil/ low taxes as an incentive for encouraging investment or offshore banking and finance. China is another significant exception, where the large earnings of state-owned corporations are available to the government [2].
Public spending requires mobilising both real (inputs; capital goods; services) and financial (money for payment to suppliers, i.e., contractors; employees; third parties) resources. Direct mobilisation of capital and labour for public spending is an option for non-market economies, as the large public sector in these countries can potentially create the capital needed for public spending [3]. These countries, however, are the exceptions. Within market economies, governments cannot directly employ resources, as they are constrained by property rights and a production model that relies predominantly on the private sector.
If governments in market-based economies rely too heavily on borrowings, this public spending will crowd out private investment and spending. When governments compete with the private sector for borrowing money from banks, firms and individuals – it may lead to higher interest rates and inhibit capital formation and consumption within the economy [4]. However, these implications would depend on whether the public spending was for legitimate and necessary purposes, as explained below. Alternatively, if the government were to simply ask the central bank to print money on its behalf and spend without borrowing, this would be an immense moral hazard. The political incumbent is likely to squander the money on transfers to its cronies and on projects aimed at its own re- election, especially before elections [5]. This moral hazard is amplified during crises like the Great Recession and the Covid Pandemic – these episodes provided ample opportunity for misuse of the money creation abilities of central banks. Income and wealth inequality and price instability were exacerbated as a result [6].
Due to the moral hazards and economic consequences of both excessive government borrowing and printing money in order to fund spending, indirect enlistment of these resources as a fraction of economic output through taxation is a reconciliatory modus vivendi [7]. Taxation is, therefore, the predominant (but not the only) source of funding government spending within market economies [8].
Efficiency
As per the social contract tradition, the agreement between the state and its citizens is that the former is responsible for directing its powers towards the public good. In the contractarian political narrative, public good is viewed as the common interests of the members of a group (e.g., the protection of life and property). Within Neoclassical economics, the term ‘public goods’ refers specifically to those goods that are ‘non-excludable’ and ‘non-rivalrous’ [9]. Non-excludability implies that it is not possible to restrict persons from consuming the good by placing barriers to access (e.g., price); while, non-rivalrousness denotes that consumption by one person will not diminish availability for others. National defence, law and order, and public sanitation are common examples of public goods.
In contrast, goods that are excludable and rivalrous are classified as private goods (e.g., food and clothing). Private goods can be supplied by the market, provided they adhere to the equilibrium (demand-supply) based pricing mechanism. Since this does not apply to public goods, the incentives needed for optimal private production are absent, resulting in market failure. Failure of the market mechanism has also been observed in the case of private goods, where the private cost- benefit calculus does not match that of social costs and benefits in many sectors of the economy [10]. For instance, due to the insufficient incentives for the private sector to set up and maintain a wide network of facilities for providing affordable healthcare, there is either a shortage in supply or other failures frequently associated with the sector. Consequently, there may be an expectation from the government to provide goods due to the private sector’s inability to match supply with demand. Moreover, quality and coverage in a market system are functions of pricing and demand [11]. Market-based pricing mechanism is unavailable to producers and suppliers for the same [12].
It is crucial to avoid such failures of quality and coverage in healthcare; education; and, research and development – to name a few. In India, the State’s commitment to provide some of these economic outcomes – such as education and employment – have already been codified within our laws as ‘positive’ socio-economic rights [13]. Additionally, governments are often required to be employers of last resort; enable counter-cyclical employment; and invest in capital intensive and priority sectors of the economy.
As market pricing is unavailable for these spending needs, taxes are the ‘price’ paid for public goods and they are calibrated typically on the ‘ability to pay’ principle (see, next section). If borrowing and spending is not for requisite productive purposes, bad economic outcomes follow – regardless of whether the misallocation is by the public or private sector [14].
Where public spending is necessary, but the information needed to make pricing decisions is not available, expecting the government to spend ‘efficiently’ may not be feasible.
Not all such market failures can (or should) be addressed by public spending alone. Market failures have been observed in public transportation, telecommunications and energy sectors as well. There are numerous instances where, instead of the public sector stepping in, the right set of incentives, guidance and regulations could redress the situation in a more efficient way. Japan’s railway network, India’s telecom sector (despite its recent woes) and private electricity supply in some Indian cities are examples of how market failures can be effectively addressed with private sector participation. However, these alternative solutions may still require either significant public spending (on administrative and regulatory agencies; subsidies; finance) or forgoing revenue (tax and other incentives; land and other concessions).
To summarise: Taxes are necessary to curb the waste and moral hazard that may be inherent in public spending. However, the government’s role as provider of public and other goods emerges from the failure of the market mechanism and statutory obligations. Some market failures in the supply of private goods can be addressed by aligning incentives through regulatory and other interventions. However, where public spending is necessarily required to address market failures, expecting the government to produce ‘efficiently’ is somewhat paradoxical.
Clarifying Statement 2
As per the conventional political-economic narrative, (e.g., John Locke’s Second Treatise of Government and Adam Smith’s Wealth of Nations), citizens are expected to pay taxes to support the government, including its function of providing public goods. Should the tax obligation be in proportion to the benefits received from the government, or in accordance with the ability to pay? Given the nature of public goods, revenue contribution cannot be assessed on the basis of their consumption (e.g., it is not feasible to calculate the units of law and order or regulatory outcomes that an individual consumes). The benefits principle is, therefore, precluded. Instead, the principle of equal (proportional) sacrifice [15], based on the ability to pay, is a commonly accepted basis for fixing tax obligations.
Income
While income as well as consumption are used as indicators of the ability to pay, taxes levied on each are not fungible in their impact on individuals and the economy [16]. Personal income taxation is, generally speaking, progressive [17]. Tax is imposed as a percentage of the taxable income, and the average tax rate [18] (total tax paid divided by total income) increases with an increase in taxable income. Exemptions and deductions give further effect to the principle of ability to pay [19]. For instance, deductions for medical expenditure reflects the understanding that individuals at similar income levels may not have equal ability to pay.
A progressive income tax essentially employs the idea of diminishing marginal utility of income for achieving distributive fairness in allocation of tax burden. A low-income earner will experience greater loss of utility due to taxation than a high-income earner, and hence, it is deemed fair that tax contributions sought from the former are comparatively lower. This is a policy choice arising from the distributive impact of taxes. If, instead, tax collection was to be Pareto efficient, a lump sum tax on each individual would be optimal (it would keep administrative costs of taxation low, not distort economic choices, and maximise revenue). Revenue maximising Pareto optimality is, therefore, not the default objective of tax policy.
Consumption
On the other hand, taxes on consumption are inherently regressive. At the outset, a person at a lower level of income or wealth spends a higher proportion of their income or wealth on consumption, with negligible financial savings (explained in the next section). Higher indirect taxes will mean that they pay a greater proportion of their income or wealth as taxes than a person who is financially better off. Tax is imposed as a percentage of the price of goods, irrespective of the income level. As a result, the GST liability of a low-income individual will equal that of a high-income earner, for the same basket of goods. The average tax rate reduces as income increases. Moreover, since the tax rate attaches to goods, the liability to pay tax cannot be adjusted to taxpayer attributes. While an income tax rate structure may be designed to not create liability for persons with incomes below prescribed levels, payment of GST on the goods they consume cannot be entirely avoided.
At low income and wealth levels, consumption is not an indicator of the ability to pay. GST law in India acknowledges this to an extent by exempting necessities (e.g., grains; pulses; fresh vegetables) and differentially taxing goods of mass consumption and luxuries. Distributive fairness in consumption tax may be achieved if tax rates are directly proportional to price elasticity of demand, i.e., lower the elasticity of demand (such as that of food items like grains and pulses) lower the tax rate. This, too, is a policy choice – if revenue maximisation were to be the aim, the optimal tax rate (meant to exploit a situation of supply monopoly) would be inversely proportional to elasticity of demand for the goods. Inequitable as that may be, high tax on goods with inelastic demand would bring more revenue since there would be limited scope to alter consumption choices.
Tax regimes often exploit this inelasticity of demand by imposing high taxes on ‘vice’ goods such as alcohol, cigarettes and gambling, as their demand does not decrease dramatically due to the additional price burden. However, taxing these goods in a revenue- maximising way is reflective of policy confusion. These are supposed to be ‘demerit’ goods with high negative externalities and therefore, the aim should be to eliminate their consumption, instead of exploiting their consumers for revenue [20]. There may be some scope for tailoring indirect taxes to influence consumption away from demerit goods with negative externalities and towards merit goods with positive externalities [21]. However, due to price (in)elasticity and classification issues with merit and demerit goods, the role of tax policy in influencing their consumption is limited [22].
To conclude: While the ability to pay principle does underlie tax obligations, consumption should not be treated as equal to income as an indicator of the ability to pay. Even in cases where higher price inelasticity corresponds with the ability to pay (such as demerit goods), the policy prerogative (in most cases) cannot be to raise revenue, thereby negating the implications of income and wealth levels.
Restating Statement 3
Where personal income tax liability is a function of the taxable income earned and the tax rate structure is progressive, high-income earners may pay a higher amount of income tax. However, if viewed proportionate to income earned, it may be less than that paid by an individual in a lower income group. The primary reason is that in progressive tax systems, generally, the marginal tax rate increases as income increases. At this point, it is relevant to appreciate the difference between marginal tax rate and average tax rate. While the average tax rate is total tax paid divided by total income, the marginal rate refers to the tax rate applicable on the last unit of income. Where the top marginal tax rate is 30% on annual income over 90,000 units, an individual earning 95,000 units will fall within the said tax bracket. However, only income above 90,000 units, i.e., 5,000 units, will be taxed at 30%. The remaining income will be taxed at lower rates; for instance, 10% on the first 30,000 units, and 20% on the next 60,000 units. As a result, while the concerned individual is subject to a marginal tax rate of 30%, the average tax rate is much lower.
Further, certain receipts like capital gains are typically taxed lower than other sources of personal income [23]. If capital gains are taxed at 20% and the above individual earned 5,000 units as capital gains, the total tax payable will reduce. Moreover, income tax statutes allow for exemptions and deductions from the gross income that typically apply to business/ professional income (e.g., all revenue expenditure incurred for the purposes of business/ profession is deductible, and depreciation deduction is allowed for capital expenditure).
Consequently, a high-income earner may pay a higher amount of income tax in absolute terms, but not relative to income earned.
Similarly, a person earning a higher income is likely to spend more in absolute terms and thus, pay a greater amount of GST. Here, it is relevant to note how marginal propensity to consume (MPC) operates. MPC refers to the percentage of an additional unit of disposable income that is used for consumption. At lower income levels, MPC tends to be high as most or all of the income is required to fulfil consumption needs. However, MPC tends to fall as income rises. At higher income levels, the proportion of income used to buy goods declines. High-income earners therefore usually spend a smaller percentage of their income on GST.
For the above reasons, statement 3 may be restated as under:
In absolute terms, persons falling within high-income groups earn, spend and are taxed more than low-income earners. However, as a function of the statutory scheme of rates, deductions, and exemptions, their tax burden relative to income level may be lower than that of individuals in lower income groups.
Responding to Statement 4
Double Taxation
In responding to the concerns raised in statement 4, the economic understanding of capital and income is being adopted [24]. ‘Capital’ refers to assets (financial/ non-financial; tangible/ intangible); and ‘income’ denotes factor income – the return received by suppliers of factors of production (labour and capital) [25]. The former generates income when employed in productive activity, which in turn enables economic decisions such as consumption and capital formation, which then feeds back into income in a recursive manner. This highlights the nature of control over economic outcomes provided by access to capital.
From the distinction between capital and income, it may be inferred that double taxation (a situation where the same tax base is taxed twice) is not inevitable where a jurisdiction taxes both. The sphere of overlap is also dependent on other applicable laws. For instance, if capital gains are treated as taxable income, or estate/ inheritance taxes are imposed, there would be double taxation; the extent of which would depend upon the tax base of each of the taxes [26]. Further, if the statutory definition of assets includes the unconsumed portion of income within its ambit for levy of capital tax, it would amount to double taxation (e.g., savings account balances). In comparison to the entirety of asset holdings of a person that would be subject to capital tax, when measured in terms of market value, such overlaps would be insignificant.
Concentration of Capital
As per the supply-side and libertarian economic narratives, imposition of capital tax is expected to influence economic behaviour to the detriment of investments and public revenue [27]. Generally speaking, supply-side economists believe that economic outcomes are better if wealth remains in the hands of the owners of capital. The assumption is that the allocative efficiency of capital works best when free from the distortionary effects of redistributive taxes. Meanwhile, emphasis on protection of private property rights and a negative view of state interference in the economy are salient to political libertarianism.
On the other hand, proponents of Keynesian theory argue that concentration of capital is correlated with under-investment [28]. Keynes theorised the relationship between inequality (income and/ or wealth) and propensity to consume, effective demand, incentive to supply and capital formation. Unequal income distribution results in untapped MPC, weakening the demand for consumption. In this view, demand stimulates production activity (supply); lack of which negatively affects capital formation. Moreover, it sets up a feedback loop (inequality resulting in underinvestment that will reduce employment opportunities and widen/ deepen inequality).
The same argument may be made through the perspective of another market failure – economic rents. Ownership and/ or control over certain types of capital (e.g., scarce natural resources or production technology) provides a structural advantage that enables usurious pricing and crowds- out other actors from income distribution. This is, therefore, negatively correlated with the ability to demand, incentive to supply and future investments [29]. Moreover, the outsized role of access to government (cronyism; lobbying; capture) – as opposed to genuine economic value – as the primary means of increasing wealth and capital has been highlighted in recent years [30]. This preferential access to the government, laws and policy are market failures and a primary source of rent. Taxing of capital as it is currently held and then re-distributing it can be justified as rent disgorgement for the purposes of addressing existing inequities.
Tax Avoidance
The long-term impact of capital tax on macroeconomic indicators depends on multiple variables including tax avoidance elasticity, net revenue collection, nature of government spending (towards targeted productive investments or otherwise), and its direct/ indirect effects on productivity. For instance, tax avoidance elasticity is an estimate of the propensity to avoid taxes. Avoidance elasticity ranges from -0.17 to -40.5 depending on the method of computation and legal design/ enforcement [31]. It has been observed that variations in estimates are conveniently contoured along the fault-lines in political and economic theory. Libertarian/conservative economists who are not in favour of capital taxation tend to ‘discover’ empirical evidence of high avoidance elasticity, whereas liberal/progressive scholars suggest that tax avoidance rates due to capital taxes are lower. That being so, projections of economic effects of a capital tax should be treated as indicative. There is no singular inevitable set of economic outcomes that will arise if a capital tax is imposed.
The ability to minimise tax liability arises out of the legal positions (deductions; exemptions; definitions; thresholds; etc.) that are adopted within tax and other related statutes. Whether these provisions are legitimate exceptions that allow an assessee to minimise taxes through ‘planning’, or they amount to loopholes resulting in tax ‘avoidance’ and ‘evasion’, is a matter of subjective policy and legal interpretation. For instance, the Indian Supreme Court has held in several decisions that tax planning within the contours of the law is valid, whereas tax avoidance and evasion are not [32]. However, this truism does not address why we have a tax regime that allows tax planning in the first place. While the scheme of taxation allows assessees to optimise their tax burden, its purpose is not individual gain in the narrow sense. In a rational taxation scheme, tax planning to the extent permissible is aimed at optimising the behaviour of individuals and firms for economic efficacy. Specific incentives and disincentives are included in tax design to ensure that the self-interest and motives of assessees align with tax policy on income, savings, investment, distribution, and so on [33]. The onus, therefore, is on lawmakers to ensure that tax planning actually enables optimisation of economic outcomes.
Redistribution and Political Power
Apart from economic reasoning, there is a political imperative for capital taxation as well. The difference principle (‘maximin’ rule) of John Rawls is an a priori mandate for wealth redistribution. As per this rule, inequalities in outcomes are tolerated for the reason that the surplus so generated be redistributed ‘to the greatest benefit of the least advantaged members of society’ [34].
Other things being equal, the least coercive arrangement would be the most liberty-compatible and therefore, preferred over alternatives. Pre-tax equality (institutional egalitarianism), as opposed to post-tax (redistributed) equality, would nominally satisfy that requirement as it does not entail coercive redistribution (such as a capital tax). In the absence of such egalitarianism, second-best alternatives such as Thomas Piketty’s proposal for a progressive annual capital tax on global wealth become relevant. The unmerited means of capital concentration and the resultant inequity make confiscatory measures an appealing prospect. Redistribution of the tax collected, through targeted government spending, would serve to bridge the inequality gap (pre and post-tax).
Outsized control over capital is the primary source of political disenfranchisement in market economies. Political control by way of disproportionate access to the legislative, policy and decision making process is a slippery slope towards state capture. Fracturing control over capital becomes necessary in order to prevent this subversion of public decision-making. Admittedly, control and ownership may not vest with the same person; nonetheless, to the extent control arises from ownership, capital taxation would be able to address the identified risk (subject to suitable design and enforcement).
To conclude: If viewed solely from the lens of property rights, levy of taxes generally and capital taxation specifically are inherently redistributive and akin to confiscatory state action. However, the economic justifications and political reasoning presented above demonstrates that such an understanding is simplistic, and that effects of taxing capital are not deterministic. A production/ economic output maximalist view is therefore not axiomatic to tax policy – it involves weighing the trade-offs and pay-offs.
Making Sense of Statement 5
History and Classification
Mercantilism was a realist doctrine guiding economic and trade policy in Britain and the rest of Europe during the 16th-18th centuries. Prominent advocates of Mercantilism at the time were Thomas Mun (England), Jean Baptiste Colbert (France) and Antonio Serra (Italy) [35]. Tariffs were a central aspect of the Mercantilist policies of that era. High protectionist tariffs were aimed at minimising imports, as the Mercantilists understood trade to be a zero-sum game with only one winner. This protectionism eventually fell out of favour, and was replaced by the free-trade advocacy of Adam Smith and David Ricardo. The repeal of the Corn Laws in 1846 by the British Parliament marked the twilight of protectionism as public policy [36]. Free-trade has been a pillar of economic thinking ever since, with some periodic exceptions.
The United States had a long history of protectionism as well. Alexander Hamilton introduced the argument that since ‘infant industries’ may not possess the economies of scale required to compete with more mature industries in other countries, they need protection in order to thrive [37]. This protectionism carried on in the 19th century under the moniker of the ‘American System’ (as opposed to the ‘British System’ of free trade). Once the infant industry argument could no longer be justified – protecting wages and agriculture, and promoting reciprocity – became the main grounds for continued protectionism. The Tariff Act, 1890 (commonly known as the McKinley Tariff Act) was enacted with these goals in mind. After a relatively short period of low tariffs, the Tariff Act, 1930 (commonly known as the Smoot-Hawley Tariff Act) reintroduced high tariffs on imports in the middle of the Great Depression.
Tariffs have remained relevant for legitimate reasons even under the free-trade regime of the 20th century. While the World Trade Organisation (WTO) framework, for the most part, is designed against protectionism – there is a recognition of harmful trade practices such as ‘dumping’ and grey areas such as production/ export subsidies. Consequently, anti- dumping and countervailing duties are allowed under the WTO framework [38]. It should be noted, however, that there is no unanimity of opinion on the consequences of these practices. While export dumping is a destructive and anti-competitive practice (a form of predatory pricing) that needs redressal, the implications of export subsidies may well be different. Milton Friedman famously argued that since export subsidies actually benefit the importing nation at the expense of the exporter by increasing the consumer surplus, retaliating against them would be akin to returning a free gift.
Revival, Legality and Underlying Assumptions
The Donald Trump administration has initiated a trade war with all the trade partners of the US The reasoning for the tariffs is confusing, to say the least. At various times, President Trump has argued that the tariffs are aimed at: a) compelling Canada, Mexico and China to stop the inflow of fentanyl into the US; b) raising revenue for the US treasury and redressing the fiscal situation; c) retaliating against the anti-competitive currency manipulation and subsidies given by the governments of exporting countries; d) reshoring manufacturing industries back to the US; e) compelling all trading partners into entering trade deals with the US on ostensibly favourable terms. Since these tariffs have been imposed on all countries (including India), they will impact the world economy in the coming months. They could lead to a retaliatory trade war, or other countries may attempt to emulate this ill-advised strategy in the near future. Awareness about their potential consequences is, therefore, crucial for informed public discourse and prudent political response.
The tariffs imposed by the Trump administration have not emanated from an Act of Congress. The administration has invoked only those provisions of law that allow the President to unilaterally impose tariffs, either with the additional requirement of a technical finding in favour of the tariffs, or dispense with that safeguard under the guise of a ‘national emergency’ [39]. Imposing tariffs without Congressional approval erodes separation of powers, as it infringes upon their mandate over tariffs and foreign commerce [40]. Had the tariffs been placed before Congress, they would be subject to extensive deliberations and scrutiny by legislators who care about how an enactment affects their own re-election. Further, imposing these tariffs specifically under the legal provisions that do not require any procedural safeguards or substantive investigation lowers the threshold of checks-and-balances for such crucial decisions.
The assertions made by the President and other members of his cabinet lead to the inference that the tariffs are premised on two principle assumptions. First, that tariffs are not taxes in the conventional sense, but are nonetheless a valid source of revenue. President Trump and his public spokespersons have repeatedly stated that the tariffs will redress the government’s fiscal deficit, and are a precursor to either a reduction in Federal income tax or its abolition altogether. Even without accounting for the consequences of the tariffs themselves, the claims about the administration’s intent to reduce the fiscal deficit are erroneous, to say the least. The Trump administration aims to permanently extend the tax cuts introduced in 2017 during his first term, which will lead to an estimated Federal revenue deficit of $4.5 trillion (before factoring in a dubious offset estimate of $710 billion for long-term increase in Gross National Product) [41]. Given the fiscal repercussions of these tax cuts, further tax reductions cannot be made without dismantling the concept of fiscal responsibility itself. Second, the assertion that tariffs are not taxes comes with a corollary – that the burden of tariffs will be borne by the exporting countries, and not by either the importing entities or consumers in the US This claim has been used to influence the perception about the tariffs and garner public support for them.
Anticipated Consequences
Revisiting the aftermath of the Smoot-Hawley Tariffs would help in assessing the potential impact of the present tariffs. Some economists have argued that the tariffs under the Act were largely responsible for the Great Depression. According to Douglas Irwin – while the tariffs did not directly cause the depression – they did exacerbate its severity. The tariffs resulted in a fall in US imports that could not be accounted for by the economic deflation underway or foreign retaliation to the tariffs [42]. They failed to create economic growth, and the fall in exports to other countries due to their retaliatory tariffs and the global economic situation exceeded the savings due to fall in imports. The unilateral actions of the US government damaged international cooperation and contributed to the political conditions leading to the rise of fascist nationalism in Europe. It would be reasonable to conclude that the Smoot-Hawley tariffs failed to achieve their intended objectives, but they did create negative repercussions and exacerbated other crises.
Back in the present, the first and immediate consequence of the present tariffs imposed by the US will be an increase in the price of imports. Regardless of the Trump administration’s claims, tariffs are, in effect, a kind of indirect tax that will lead to an overall increase in the prices paid by US consumers. This price rise is expected to be about 1.3% in the short run, and will reduce the purchasing power of US households by $2,100 on average [43]. This will reduce overall consumption by about 3.5% by 2030 [44]. It is difficult to assess the precise extent of impact on consumption immediately, as it will depend on four variables that are not readily ascertainable. First, the extent to which large importers like Amazon and Walmart – or the US government – are able to leverage their bargaining position to force the exporting businesses into absorbing the impact of the tariffs. Considering that none of the credible economic surveys have included this aspect in their impact assessment, it would be safe to assume that this would be a negligible factor.
Second, the extent to which businesses pass on the burden of the tariffs to their customers would depend on the supply and demand elasticities of the imported goods themselves. If customers consider certain goods to be essential, they will buy them even at increased prices, but that would result in diminished purchasing power and forgone purchases elsewhere. Third, estimating the impact on prices and consumption becomes difficult in the face of the constant carve-outs and rate adjustments which the administration has been announcing since April 2, 2025. Fourth, the impact assessment surveys have not factored in the rise in prices of intermediate goods, and they cannot, therefore, determine the final impact on the price of finished goods. The second point mentioned here is particularly relevant, as it further emphasises the inherently regressive effects of these tariffs. In Part 2, we have explained how taxes on consumption are inherently regressive, and it is especially so in case of necessities demanded by lower income households. The impact surveys corroborate the assumption that the financial impact of the tariffs will be relatively higher for those in the lower income brackets.
The claim that these tariffs will increase revenue is misplaced optimism. An increase in revenue cannot be viewed in isolation from the context. It needs to be better in comparison with alternatives, and the long-term benefits should outweigh the costs incurred. The distributional impact of an uncalibrated sales tax on lower income households has already been mentioned. Even if we were to disregard this inequity, these tariffs are worse than alternative sources of revenue. As per the Penn Wharton Budget Model, the tariffs are expected to raise the same amount of revenue as an increase in corporate income tax from 21 to 36 percent [45]. While such a sharp increase in corporate income tax would lead to some negative economic outcomes, the reduction in GDP and wages due to the tariffs would be more than twice as much. There will be an estimated revenue loss of $366 billion from contraction in output over the decade [46]. It is pertinent to note that information about possible retaliatory measures by other countries is not immediately available, and the estimates about these are, therefore, either unreliable or have been assumed away for now. Due to the assumptions about elasticity, intermediate goods and possible retaliation, the impact assessment figures are best-case scenarios; the actual negative impact is likely to be worse than these initial estimates.
The negative impact on the US economy will be even greater due to the fact that the expected compensatory gains from the tariffs are unlikely to materialise. Donald Trump has promised that the tariffs will bring back manufacturing jobs to the US This claim is both counterproductive and unrealistic. First, international trade is predicated on comparative advantage and ‘mutual gains from trade’. While these gains have often not accrued to the Global South due to unequal bargaining and unfair ‘rules of the game’, the US has gained more from this arrangement than any country in the world. The gains in ‘consumer surplus’ to US consumers and higher profit margins for US corporations due to cheap imports from other countries is greater than it would be if those goods were made in the US. The cost of inputs – wages; land; technology, etc.; – are higher in the US than in most other nations. It would be impossible for their manufacturers to produce and sell goods at prices that do not lead to a drastic fall in purchasing power and consumption demand. While the US does retain some manufacturing prowess in complex technologies – such as aviation, semiconductors and automobiles – prior experience has shown that entire supply chains do not shift due to policy shifts and political pressure. The US government managed to successfully reduce Japanese car imports in the 1980s after persistent pressure; but the only real change it led to was that cars were now assembled in the US from imported components, at a significant cost to consumers.
Second, the tariffs will not result in new investment in the absence of a planning mechanism, public investment and industrial policy which are antithetical to the US economic system at present. Ever since the Reagan administration, economic policy in the US has been biased towards minimal State intervention in economic affairs, low taxes and primacy of the market mechanism. In this model, planning and industrial policy are considered distortionary interventions leading to sub-optimal results. Threatening other countries and domestic corporations with punitive measures can only achieve so much. Without the necessary support towards identification of priority sectors, investment in the necessary supply-chains and policy/ financial/ regulatory assistance, it is unlikely that manufacturing can be revitalised in any country, including the US. For instance, while imposing the present tariffs, the Trump administration did not even discriminate between goods meant for final consumption and intermediate goods. Manufacturing within the US will become more expensive and uncompetitive compared to other countries as a consequence. This is indicative of the fact that the US government has no interest in actually supporting manufacturers except through threats and pressure tactics.
Finally, businesses and economies do not thrive in an environment of uncertainty. The constant barrage of announcements about exceptions to the tariffs for specific industries and rate changes demonstrates that these decisions are more about lobbying and access to decision-making than any actual economic reasoning. Apart from the confusion and corruption that this demonstrates, it is bad for both business and consumer confidence. Businesses will not be able to make long-term investment commitments when they face the kind and intensity of policy uncertainty on display at the moment. Whether the Trump administration is able to bully other countries into signing favourable trade deals remains to be seen. In the meanwhile, the present tariffs are likely to harm the US economy and consumers to a significant extent.
To conclude: Protectionist tariffs arose from Mercantilism, which was the dominant economic idea before the advent of free trade. While free trade has its disadvantages, especially for the post-colonial Global South, reverting to zero-sum Mercantilism would be to no one’s benefit. Tariffs increase the cost of manufacture, make consumer goods expensive and reduce the purchasing power of consumers. They are regressive and will impact low- income households more than others. As a source of revenue, they are worse than other options and will lead to economic contraction. Hoping that manufacturing will be revitalised due to tariffs is futile in the absence of planning, industrial policy and State support.
[1] Mario Mansour and others, ‘Methodology and Overview of the IMF’s World Revenue Longitudinal Database’ (2025) International Monetary Fund 7 <https://www.imf.org/en/Publications/TNM/Issues/2025/03/06/Methodology-and-Overview- of-the-IMFs-World-Revenue-Longitudinal-Database 557352> accessed on 24 May 2025.
[2] Structural reasons (reducing wasteful and redundant spending; improving management and efficiency) for disinvestment in public sector entities are plausible in the context of public sectors that encroach on legitimate private economic activities. However – where the public sector is responsible for public and essential goods; redressing market failures; capital investment; and, countercyclical spending – funding government spending by selling public assets is a recipe for financial and economic failure in the long-run.
[3] ‘Non-market’ economies are those where the state intervenes directly within the economy by making production decisions and employing resources, instead of relying on the market pricing mechanism and private entities.
[4] The reason governments need to borrow from the market is due to legal design. In most countries, there is a rule prohibiting the central bank from monetising the government’s spending and debt. This implies that in order to spend, the government will need to issue treasury instruments either to the central bank or the financial market, which drains liquidity from the financial system in order to prevent price instability. For the legal position in India, refer section 5 of the Fiscal Responsibility and Budgetary Management Act, 2003. For the US, EU, and UK, refer Will Bateman, ‘The Law of Monetary Finance under Unconventional Monetary Policy’ (2021) Oxford Journal of Legal Studies 1.
[5] Jose Fernández-Albertos, ‘The Politics of Central Bank Independence’ (2015) Annual Review of Political Science 217, 220; Eric Dubois, ‘Political Business Cycles 40 Years After Nordhaus’ (2016) Public Choice 235, 236. Even in non-market economies, if public spending was not being incurred for productive purposes, it would lead to inflation in the long run.
[6] Lucas Chancel and others, World Inequality Report, 2022 (World Inequality Lab). For granular country-wise data, refer to the World Inequality Database website.
[7] Tax to GDP ratio is widely used to assess control over economic resources of a state by its government. The most recent analysis for OECD countries is available at <https://www.oecd- ilibrary.org/sites/6e87f932 en/index.html?itemId=/content/publication/6e87f932-en> accessed on 1 May 2025.
[8] In Blog 3 (on the mechanism of public finance), we will explain how government pending is actually financed through a necessary mix of taxation, borrowings (domestic/ foreign) and money creation. In Blog 4, we will elaborate on the role of taxation in directing an economy.
[9] E.g., Paul Krugman and Robin Wells, Economics (4th edn, Worth Publishers 2015) (Chapter 17).
[10] In the context of healthcare, Kenneth Arrow’s seminal work has highlighted the multi- dimensional nature of market failure. For detailed discussion on the issue, refer Kenneth Arrow, ‘Uncertainty and the Welfare Economics of Medical Care’ (1963) 53(5) The American Economic Review 941.
[11] Allocative efficiency depends on recording and synthesising production, pricing, and consumption decisions to reveal consumer needs and preferences. Heterodox economists such as Friedrich Hayek have observed that states would be unable to collect and process all the necessary information through top-down control-based systems; therefore, leaving allocation decisions, largely speaking, to the market.
[12] In the absence of the market pricing mechanism, Ramsay pricing and related optimal taxation are the default basis for providing public goods. As per the (default) Ramsey pricing rule, prices of public goods should be inversely proportional to the elasticity of demand – i.e., the mark-up on the marginal cost would be highest where the demand is price inelastic and lowest, where the demand is price elastic. E.g., Kenneth E. Train, Optimal Regulation: The Economic Theory of Natural Monopoly (MIT Press 1991) (Chapter 4).
[13] The Right of Children to Free and Compulsory Education Act, 2009; Mahatma Gandhi National Rural Employment Guarantee Act 2005. Others have been recognised, but have not been formalised in law as yet. E.g., Ayushman Bharat, which is a public healthcare scheme recommended under the National Health Policy 2017.
[14] E.g., Viral Acharya and others, ‘Zombie Credit and (Dis-)inflation Evidence from Europe’ (2024) The Journal of Finance 1883. An accessible version is available at <https://pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/Zomb eCreditDisinflation.pdf>. As per the authors, zombie lending to impaired firms lead to wasteful and disinflationary outcomes in the Eurozone.
[15] “Equal proportional sacrifice means that everyone forgoes the same percentage of utility in paying taxes.” H.P. Young, ‘Progressive Taxation and the Equal Sacrifice Principle’ (1987) Journal of Public Economics 203, 204.
[16] Income and consumption taxes impact the economy differently. The discussion in Blog 4 on the role of taxation in an economy will cover this aspect.
[17] E.g., Paul Krugman and Robin Wells, Economics (4th edn, Worth Publishers 2015) Ch 7.
[18] Average tax rate is also sometimes referred to as effective tax rate.
[19] Not all exemptions and deductions are meant to reflect ability to pay. Some of them are meant to influence individual behaviour towards savings, investment and consumption. This is especially the case for corporate taxation, where taxes are meant to direct what companies do with revenue and profits.
[20] Pigouvian taxes are meant to address market failures due to which the negative externalities (harm on others) of a product are not reflected in its pricing. An effective Pigouvian tax is seldom aimed at raising revenue. That would require – quantification of the costs; proven ability at financial mitigation thereof; and evidence that the revenue generated from the tax is indeed used for its mitigation. In most situations, therefore, the aim is that the tax inhibits consumption of the harmful product and tax collection eventually approaches zero.
[21] Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and Practice (5th edn, Mc-Graw Hill 1989) Ch 4.
[22] According to Richard Musgrave, the public benefits of consuming merit goods are higher than the private benefits from doing so. Since consumers usually do not consider public benefits (or costs) while making consumption decisions, merit goods are under- produced.
[23] The common argument for taxing capital gains at a lower rate is that by improving the rate of return on investments, supply of capital will be incentivised, which in turn is presumed to be directly correlated with economic growth. E.g., Len Burman, ‘Capital Gains Tax Rates and Economic Growth (or not)’ (Forbes, 15 March 2012) <https://www.forbes.com/sites/leonardburman/2012/03/15/capital-gains-tax-rates-and- economic-growth-or-not/?sh=2b2fa83f1e2e> accessed on 24 May 2025.
[24] For e.g., The Indian income tax legislation (Income Tax Act, 1961) defines ‘capital asset’ and ‘income’. However, that is a legal and not an economic definition. It reflects a necessary pragmatic adjustment of concepts as per needs. Similarly, there are definitions of capital within accounting and securities/banking laws as well.
[25] E.g., Paul Krugman and Robin Wells, Economics (4th edn, Worth Publishers 2015) Ch 2 and 9.
[26] Some countries, such as Singapore, do not tax capital gains. See <https://taxsummaries.pwc.com/quick-charts/capital-gains-tax-cgt-rates> for a comparative study of capital gains tax rate for identifying other such countries. Even where capital gains/ capital/ wealth is taxed, exemptions/exclusions are common. See Thomas Piketty, Capital in the 21st Century (Harvard University Press 2014) at 517-518. The definition of ‘capital asset’ in India’s Income Tax Act, 1961 is illustrative – it excludes certain asset classes such as agricultural land.
[27] Concentration of capital is legitimised within the aggregate production/ utility maximising framework. As production/ utility maximisation is the rule in this framework, distributive implications for the group are not considered relevant as long as the aggregate increases. Consequently, they advocate lower taxes on the income of the wealthy and no taxes on capital. A common libertarian slogan is that taxation is theft. It is argued that confiscation by the State of the gains made from legitimate economic choices is a violation of property rights; and, is a disincentive for the operation of free markets, supply of capital, and wealth creation. E.g., Bas van der Vossen, ‘Libertarianism’ (The Stanford Encyclopedia of Philosophy Spring 2019 Edition) <https://plato.stanford.edu/archives/spr2019/entries/libertarianism/>.
[28] John E. Elliott and Barry S. Clark, ‘Keynes’s “General Theory” and Social Justice’ (1987) Journal of Post Keynesian Economics 381.
[29] Mariana Mazzucato and others, ‘Theorising and mapping modern economic rents’, UCL Institute for Innovation and Public Purpose’ (2020) Working Paper Series (IIPP WP 2020-13) section 3 <https://www.ucl.ac.uk/bartlett/public-purpose/wp2020-13> accessed 24 May 2025.
[30] Thomas Piketty, Capital in the 21st Century (Harvard University Press 2014); Katharina Pistor, The Code of Capital (Princeton University Press 2019).
[31] John Ricco and others, ‘Senator Elizabeth Warren’s Wealth Tax: Budgetary and Economic Effects’ (Penn Wharton, University of Pennsylvania, 12 December 2019 <https://budgetmodel.wharton.upenn.edu/issues/2019/12/12/senator elizabeth-warrens- wealth-tax-projected-budgetary-and-economic-effects> accessed 24 May 2025.
[32] McDowell & Co. Ltd. v Commercial Tax Officer AIR 1986 SC 649, Union of India v Azadi Bachao Andolan AIR 2004 SC 1107, Vodafone International Holdings B.V. v Union of India (2012) 6 SCC 613.
[33] For instance, differential tax rates for savings, interest from fixed deposits and capital gains are not only due to a progressive tax policy, but are also aimed at directing savings towards specific investments. In corporate taxation, the difference in treatment of share buybacks and dividend distribution influences what companies decide to do with their cash reserves.
[34] John Rawls, A Theory of Justice (Harvard University Press 1971).
[35] Mercantilism, Britannica.
[36] The Corn Laws were impositions of tariffs and other restrictions on the import of cereal grains.
[37] Paul Bairoch, Economics and World History: Myths and Paradoxes (Paperback edn, University of Chicago Press 1995) (Chapter 3).
[38] The Agreement on Implementation of Article VI of the General Agreement on Tariffs and Trade 1994 (Anti-dumping Agreement) and The Agreement on Subsidies and Countervailing Measures. In India, the Customs Tariff Act, 1975 is the relevant legislation that allows for such measures under sections 9A and 9, respectively.
[39] In March 2025, President Trump imposed 25% tariffs on automobiles and auto products. These tariffs were imposed under section 232 of the Trade Expansion Act, 1962, following an investigation by the Secretary of Commerce concluded in 2019. The subsequent tariffs on Canada, Mexico and China, as well as the tariffs announced on April 2, were under the International Emergency Economic Powers Act, 1977.
[40] Kathleen Claussen and Timothy Meyer, ‘Economic Security and the Separation of Powers’ (2024) University of Pennsylvania Law Review 1955.
[41] Erica York and others, ‘Budget Reconciliation: Tracking the 2025 Trump Tax Cuts’ (Tax Foundation, 13 May 2025) <https://taxfoundation.org/research/all/federal/trump-tax- cuts-2025-budget-reconciliation/> accessed on 24 May 2025.
[42] Douglas A. Irwin, Peddling Protectionism: Smoot Hawley and the Great Depression (Princeton University Press 2011) Ch 2.
[43] ‘Where We Stand: The Fiscal, Economic, and Distributional Effects of All U.S. Tariffs Enacted in 2025 Through April 2’ (The Budget Lab at Yale, 2 April 2025) <https://budgetlab.yale.edu/research/where-we-stand-fiscal-economic-and-distributional- effects-all-us-tariffs-enacted-2025-through-april> accessed on 15 May 2025.
[44] Felix Reichling and others, ‘The Economic Effects of President Trump’s Tariffs’ (Penn Wharton Budget Model, 10 April 2025) <https://budgetmodel.wharton.upenn.edu/issues/2025/4/10/economic effects-of-president- trumps-tariffs> accessed on 15 May 2025.
[45] ibid.
[46] ibid (n 43).