Thoughts on economics and liberty

Tag: Freedom First articles

Reforming our electoral system is better than replacing it

[This article was published in the June 2010 issue of Freedom First. I’ve slightly amended the title for greater clarity]

A range of electoral systems can provide some form of democratic representation.[1] These include proportional, first-past-the-post and the presidential. India’s follows the Westminster first-past-the-post model (which I refer to as WFPTP).

Every few years someone or the other raises a demand for replacing our system with something else. But as Robert Dahl observed, “A country where the underlying conditions are highly favourable can preserve its basic democratic institutions under a great variety of constitutional arrangements”[2]. Electoral systems are less important than the democratic culture of a society.

The great importance of incentives

But this is not enough. In Breaking Free of Nehru (BFN), I argued that incentives are more important than electoral models. “The quality of governance in a society”, I suggested, “ultimately depends on the design of the incentives deep inside the entrails of these models” (p.89). Two electoral models that look alike on the surface can deliver dramatically different outcomes based only on slight differences in their incentives.

A good system should create incentives for good people to contest elections. It should ensure that if good people do step forward to contest elections, that they have a reasonable chance of getting elected. (By a “good” person I mean someone who obeys the laws of the land, does not use illegal money during elections, does not lodge false electoral expense accounts, and is reasonably competent on matters of policy.)

I believe that what matters the most in this regard is whether:

  • a system imposes electoral expenditure limits (imposing limits violates freedom of expression and strongly encourages the use of illicit influence);
  • the government funds elections (if not, then the corrupt or the rich will step forward since only they can afford to huge expense of contesting elections); and
  • representatives are paid well (not doing so will attract only the incompetent).

Advantages of the Westminster FPTP model

Not all models are alike, either. The WFPTP system is actually quite a good model. It gives a strong mandate to the party that is supported by the largest number of voters, regardless of whether the majority supports the party. Where necessary, the largest party can align with a few small parties or independents to form a coalition. The WFPTP system therefore ensures stability.

But far more important to democratic evolution of the society is the ability of the WFPTP system to allow fresh blood and new ideas by keeping the barrier to entry quite low. Thus, the BJP could enter Indian politics even though its vote share never crossed 37 per cent nationally. Indeed, an Indian liberal party can also succeed under the current splintered polity by securing fewer votes than it would otherwise need.

On the other hand, the proportional system precludes powerful reforms of the sort that Margaret Thatcher undertook. Its coalition cabinet is generally a rabble of competing interests. Compromise and horse-trading are its hallmark. As a result, no party’s electoral promises are ever fulfilled, making a mockery of democratic accountability. Proportional is the worst of all systems.

The presidential system is very stable, but stability is not the only virtue. Responsiveness is equally important, and in this regard the presidential system performs the worst since a president can’t be removed before his tenure ends. Jokers and dunces, once elected, are free to squander taxes till the end of their tenure. The proportionate is the most responsive of all, allowing re-alignment of governments even within a given parliament. But this is chaotic, and at the expense of stability.

The WFPTP model walks the fine balance. “No confidence motions” allow the people some ongoing control on the government should it stray too far. While the US Senate can’t vote out a non-performing president, the WSFPTP can easily get rid of a non-performing Prime Minister, as well as re-align an entire government through defections. The WFPTP system is therefore the most reasonable of all; a system India is advised not to let go of!

Reforms needed

Of course, we all know that our WFPTP model is in shambles. Indeed, our entire democracy is a sham. Thus, for the last many decades, the corrupt have most successfully contested elections. But this is not a mandatory requirement of the WFPTP system. It is the result of misaligned incentives that we have chosen to create in India. We have damaged our system and so it is we who must fix it.

The relative performance of the Indian and Australian systems[3] clearly demonstrates that incentives matter. The Australian system elects brilliant and honest representatives but the Indian system prevents honest candidates from contesting.

We impose election expenditure limits – which should not exist in the first place – but more problematically, which are shamelessly and heavily breached by all the major parties. And no one in India ever audits electoral expenses! Citizens can readily obtain a copy of these records for one rupee, but they don’t care about this, either! Hypocrisy rules. In Australia and USA, on the other hand, electoral expenditure limits are not imposed. Instead, transparency and disclosure of receipts and expenses is enforced. That encourages honesty.

A good candidate in India can lose huge amounts of money in elections and even go bankrupt. On the other hand, Australia reimburses candidates on the basis of the votes polled, thus reducing the risk of losing huge amounts of money during the electoral contest. This allows good people to contest.

Finally, to totally make sure that no honest person can ever dram of entering politics (after ensuring that they will first go bankrupt!), India pays its representatives very poorly. Australia pays its representatives quite well, instead. That allows good people to join politics, something that can’t happen in India.

Indeed, with such incentives, nothing would change even if we had a presidential system. For then, instead of our most corrupt citizen becoming Prime Minster, our most corrupt citizen will become President!

These badly designed incentives have totally destroyed the WFPTP system in India. The suggested improvements will definitely enhance the performance of our electoral system, as thousands of currently disenfranchised good people start entering politics for the first time since independence.

Of course, these reforms won’t be a panacea for India’s problems. These reforms can’t ensure that elected representatives won’t abuse their powers. That will requires many other things including citizen vigilance. But of this we should be very sure: without implementing these reforms, we will always remain a banana republic.

Freedom Team of India

None of these reforms will be implemented by the current crop of Indian politicians, for they will instantly lose their seats if good people enter politics. So it is now up to the Indian liberals to (finally!) take responsibility for their country, contest elections and form a government, so these reforms can be implemented. You can do so by joining the Freedom Team of India (http://freedomteam.in/).


[1]See the International IDEA Handbook of Electoral System Design on the internet.

[2]Dahl, Robert A., On Democracy, New Haven: Yale Nota Bene, 2000 (1998), p.139.

 

[3]I’m making certain simplifying assumptions here about the Australian system which is a preferential voting system, not strictly an FPTP system.

 

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Environmental policy in a free society

(This article was published in Freedom First, May 2010).

The liberal is deeply committed to a clean and healthy environment. Sadly, India’s continuing fascination with socialism and centralised approaches has converted the country into a toxic garbage dump: our rivers and lakes are badly damaged, our wildlife and rare fauna are threatened with extinction.

Bad stewardship of the environment harms both our health and wealth. Toxic waste, polluted air and filth harms our health, but the economy suffers as well. For instance, we don’t get as many visitors to the Taj Mahal as we could have because the moment they enter Agra, obnoxious stink overpowers them. Similarly we lose many economic opportunities because we can’t develop nature sports or tourism in ravaged and filthy natural habitats.

Socialism, the enemy of the environment

Nehruvian socialism harmed India’s environment in many ways. Despite so-called family planning, socialist policies directly led to a dramatic increase in India’s population. For details please see Breaking Free of Nehru (page 233, http://bfn.sabhlokcity.com/). While a large population can be very good for a nation, it can prove fatal for the environment if the government is corrupt and incompetent and does not hold this large population to account for the harm caused.

Also, while wealthy societies have the wherewithal to clean up their rivers and lakes, socialist societies like India can’t afford to do that. And our governments lack any capacity whatsoever to enforce any law. Instead, our corrupt lawmakers and their cronies have looted our natural resources for 60 years, and connived with industries that harm the environment.

Freedom is not license to harm

What would happen differently if India were to some day become a free society? In a free society everyone is accountable for the harm they cause. There is no freedom to pollute. Negative externalities are their heart ethical and governance failures (not ‘market failures’, as economists like to call them). A free society simply does not tolerate ethical or governance failures.

This task – of environmental stewardship in a free society – is not trivial. The harm caused cannot always be easily attributed to a particular individual. Those who cause harm do not voluntarily come forward to disclose their polluting activities, either. Indeed, in some cases entire societies collude to pass on costs to future generations! Harm such as acid rain can also spread across national borders. Environmental policy is thus a very challenging area. But by carefully investigating incentives, the free society can achieve reasonable solutions and maintain a healthy environment without reducing economic activity unnecessarily. Let me outline some of these solutions.

Non-regulatory solutions

The mere existence of negative externalities should not be assumed to call for government intervention. Where affected parties can identify each other clearly and the cost of negotiation is low, the externality can be mitigated through bargaining (see Ronald Coase’s 1960 paper, The Problem of Social Cost). The government must therefore seek to clarify property rights and not rush into taking direct action. The use of intelligence, not brute force, is called for.

This also applies to the preservation of flora and fauna. If businesses are allocated property rights to rear and sell endangered species, then the supply of these species will increase, removing the threat to their survival. It is beyond belief that we even try to lecture others to stop using ivory, rhino horns or tiger skins. By the time we stop our puerile lectures to Chinese smugglers, all our precious animals would have died.

When have prohibitions ever worked? Legalising (and appropriately regulating) trade in environmental goods is crucial if we want a healthy environment. Let India earn an honest living from its fauna, not endanger its tigers and rhinos through socialist policies that only end up benefitting smugglers and arms dealers. I have absolutely no doubt that without well-regulated property rights and legalised trade, all endangered species in the world will die out.

Regulatory solutions

The property rights option may not be feasible in all cases (although its applicability is quite vast). Where direct government intervention is considered necessary, the costs and benefits of all options should be carefully scrutinised and only the most effective (and efficient) solution deployed. Options include:

a) Market based instruments: Creating markets for externalities, such as cap-and-trade schemes, can sometimes be viable. In these schemes, polluters receive signals directly from the market about whether they should spend money to reduce pollution or simply buy permits to pollute. 

b) Mandatory change in behaviour: After a cost-benefit analysis, a government could, in some cases, mandate the use of non-polluting technologies. This direct approach can minimise economic harm while reducing pollution. Mandatory restrictions or standards could be relevant for positional arms races in which it is not in anyone’s interest to stop the harmful activity unless everyone else gives it up. Thus, athletes would use increasingly greater amounts of anabolic steroids unless everyone was prohibited from using them.

c) Mandatory insurance and good behaviour bonds: Where the risk of environmental harm is considerable, mandatory insurance requirements can be imposed as part of licence conditions for starting a business. In some cases, good behaviour bonds can be mandated in lieu, although these tend to lock up valuable capital.

d) Pigovian tax: In this case a tax is imposed on the polluter. The tax is equal in value to the harm caused. The polluter internalises the costs imposed on others, and is therefore motivated to reduce the pollution. Where specific polluters can’t be readily identified, Pigovian taxes can be imposed on upstream activities that contribute to the pollution (for instance, a general tax on all cars regardless of the actual pollution caused by a car). It is important that Pigovian taxes are offset by reducing taxes elsewhere, else resources will be transferred from the private sector to government, leading to a drop in productivity.

e) Criminalising the harm: Where extremely severe harm can be caused, such as by the transportation of dangerous goods without appropriate precautions, criminal penalties can be imposed. Prohibitions may also appropriate where identifying a specific polluter is difficult or a single polluter causes only a small part of the harm. An example is the ban on smoking in bars where no specific individual can be held responsible for cancer that a bartender may develop after working in a smoke-filled environment.

In addition, there are many other ways to preserve the environment. The problem that India faces, however, is that none of these ideas are either tried, or if tried, implemented faithfully by its corrupt governments.

Freedom Team of India

The solution for India is for its liberals (such as the readers of this esteemed magazine) to take responsibility for India and work to directly improve India’s governance. The Freedom Team of India (http://freedomteam.in/) is a team of leaders who will, when ready, contest elections under the banner of liberty and provide good governance to India. Unfortunately, the team has struggled over the past two years to find enough leaders to start a serious political movement. I trust you will help in some way.

ADDENDUM

Horns, claws and the bottom line

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Wanted a Constitution that Delivers Life and Liberty

(Published in Freedom First, April 2010)

India’s Constitution is in many ways a product of British and American liberalism. We can almost hear the voices of John Locke and Thomas Jefferson in its passages. Nevertheless, the ravages of Nehruvian socialism and confused thinking of 60 years have taken a huge toll on our social contract. The Constitution is now totally irrelevant to the defence of our life and liberty.

The only way out is to re-write it from scratch. The suggestions I have made in my 2008 book Breaking Free of Nehru (BFN: http://bfn.sabhlokcity.com/) are summarised below.

Too long

When we buy an air ticket we read the contractual conditions. But we don’t care to read our social contract, the Constitution, which is a far more important document. That’s probably because it is too long. Its extraordinary length comes from the inordinate trivial detail which it delves into, in areas best left to routine law-making. It is almost as if members of the Constituent Assembly didn’t think that future generations could think for themselves (maybe they were right?).

Prescriptive

This also means the Constitution is too prescriptive, blocking innovation. Thus, our colonial (and totally unaccountable) bureaucracy is fully sheltered by our Constitution. Why should a bureaucracy – a mere agency of our representatives – even find mention in a Constitution?

After it is thus re-written for simplicity and clarity of outcomes sought, it should not exceed 10 pages. That would also help our children understand it and grow up into citizens who can defend their life and liberty. Not like the confused ‘educated’ citizens of today who have no understanding of citizenship.

Overflowing with jargon

Our Constitution makes use of abstruse jargon that confounds. For instance, why is ‘freedom’ a ‘fundamental right’? Such language (of ‘rights’) should be strictly avoided anyway, being highly misleading. All ‘rights’ originate from the process of justice which is applicable to actions of free peoples. So we can talk about one’s freedom to own justly acquired property. Such simple language is enough. Indeed, nothing needs to be mentioned but two things: life and liberty (subject to accountability).

Too many objectives

Our Constitution lists too many objectives that are often irrelevant, redundant, or mutually contradictory. The concept of ‘fraternity’ comes from the French, but why do we need to add this meaningless word into the Constitution? Whether I fraternise with anyone is purely my personal choice. A social contract can’t tell me to do so. And why only restrict ourselves to fraternity? Why not add 1000 things like: Joviality, punctuality, hygiene, perseverance, etc. There is clearly no need to litter the Constitution with idle exhortations. Similarly, ‘equality of status and opportunity’ are mere corollaries of equal liberty. Give us equal liberty and these follow.

The Preamble talks about ‘social justice’. Could anyone tell us what this means, for justice can never be social; it is always individual. Finally, even Karl Marx gets a voice in our Constitution. Indira Gandhi’s 42nd Amendment introduced the words socialism and secularism. Socialism, as we all know, is an extremely dangerous anti-liberty political philosophy that has killed millions of people across the world. Why should we be socialists?

And the word ‘secularism’ is totally confusing. A Constitution can be secular by not referring to ‘religion’ anywhere in the document. Indeed, this grab-bag of objectives has merely empowered our governments to interfere in our lives. We only need life and liberty. Period.

Unwanted Lecturing

The Directive Principles of State Policy constitute a gratuitous lecture on policy. This gratuitous advice must be rejected outright. We can think for ourselves. Worse, feeble minds get confused by this lecture. For instance, Nehru thought that ‘It is up to Parliament to … make the Fundamental Rights subserve the Directive Principles of State Policy’. Had he succeeded even remotely in this crazy interpretation, India would have been dismembered by now. Let policies be proposed by political parties and let voters decide what they want. Not the Constitution.

Steep Decline in Liberties

The first Constitutional Amendment (of 1951) started the ceaseless destruction of our freedoms that has been the pattern across all amendments. It destroyed our freedom of occupation. Today not only can a government enter into any business it chooses to, it can entirely exclude citizensfrom that business.

Similarly, freedom to own property has by now disappeared. Nehru said that socialism would require ‘the ending of private property, except in a restricted sense’. Therefore he enacted land ceiling acts (called, very perversely, ‘land reforms’), sheltering these from judicial review under the Ninth Schedule of the Constitution. The 25th amendment then removed the concept of compensation when a government acquires land. Finally, in 1978,the Janata Party abolished Constitutional property rights altogether.

Today, property is an ordinary legal right that can be truncated, even destroyed by ordinary majority in ordinary legislatures. No wonder huge amounts of capital have flowed out of India. No one trusts Indian governments.

Unequal Treatment of Citizens

Our Constitution speaks about equal status but immediately divides citizens into tribes, castes, religions, and gender. Sociologists and anthropologists can use these fuzzy terms and write tomes on them. But the state is a legal entity and must only recognise one category of citizen, namely, Indian. It is crucial that all discriminatory distinctions among people (like reservations) are banished from the social contract as soon as possible. Let social evils be fixed by social reformers, not by the state.

It is true that the state may choose to (as I argue for) provide equal opportunity through high quality school education for all children and the elimination of poverty. (This is a policy matter, not to be included in the social contract!) But the state can’t give different ‘types’ of Indians different privileges. By creating reservations, our Constitution has perpetrated grave injustice on innocent people who have been punished for no crime of theirs. Affirmative action has increased, not decreased, caste-based consciousness. And divided the entire nation.

Mixing the state with religion

The Constitution declares India to be ‘secular’ but then soaks itself in religion! It not only recognises religions like Hinduism, Sikhism, Jainism and Buddhism, and religious ‘minorities’, castes and ‘backward’ groups; but talks about prohibition of cow slaughter and Hindu religious institutions. The government is also empowered to operate religious institutions.

(And why does it not recognise ‘Sabhlokism’ – my religion! – I object to my religion not being included in the Constitution!)

How to Get Ourselves a Decent Social Contract

In BFN I have outlined a systematic process to get ourselves a better constitution. I have also proposed a bare-bones new Constitution (for whatever my suggestions are worth). I suggest that this new Constitution be approved by a referendum. And that knowledge of the social contract be made a pre-requisite for registering voters.

Freedom Team of India

Ultimately, no piece of paper will protect our freedoms if we are not passionate about our freedoms and do not remain vigilant. That is why the Freedom Team of India (FTI) exists: to advance freedom in India. A detailed report on FTIs first conference in Mumbai is available at http://freedomteam.in/. Please read it in the FTI magazine. I look forward to your support of FTI’s work. Become a Freedom Partner. 

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A liberal perspective on taxes – Part II

[This write-up was published in Freedom First, December 2009]

Sanjeev Sabhlok

Last month, in the first part of this article I made the comment that internally consistent theories of public finance simply don’t exist. I then went on to (bravely!) propose an internally consistent theory derived from the basic social contact.

The following principles resulted from that analysis, that (a) citizens (and not companies) should pay taxes; (b) paying taxes must be mandatory unless someone is simply unable to pay; (c) taxes should be based on the annual average of the lifetime worth of an individual; and (d) taxes must price-discriminate with a modest level of progression: the marginal rates approximating the overall share of taxes in GDP.

According to the fourth principle, the middle class should pay an income tax at a marginal rate approximately equal to the proportion of overall taxes to GDP; the rich should pay at a rate slightly above this; and those below the poverty line should not pay taxes, receiving a negative income tax as part of the social insurance scheme, instead.

The right level of taxation

A fifth principle suggests itself: the total amount of tax collected should be neither too much nor too little, being just enough to ensure effective delivery of necessary government services. The liberal believes that when governments are restricted to their proper role they provide us with a crucially needed service. In this regard it may be noted that a society comprising a larger share of honest people (like Japan) will need less policing and hence lower taxation. Corrupt societies will need higher levels of taxation.

In any event, the liberal is not smitten by the mindless fascination of some alleged ‘liberals’ for low taxation. It is crucial to have the right size of government with right services and functions. That is the only correct determinant of the right level of taxation. Today, India’s socialist government imposes an extremely low overall tax burden but then it squanders these precious revenues on totally unnecessary activities.

The consequent under-supply of basic public goods like defence, police and justice – including the defence of property rights – has led to significant crime and poverty in India.

The ever-present specter of regressive taxation

Theoretical models of public taxation are extremely difficult to translate into practice. We noted last month how regressive taxation is the norm across the world. The rich pay proportionately less as they get richer. At the same time, the poor (who, we have noted, should not have to pay taxes) fork out heavy consumption and indirect taxes. The most progressive taxes of all are reserved for the salaried upper middle class, which carries the world on its shoulders.

The rich benefit most from any number of exemptions, including a regressive capital gains tax regime. Assume that A and B have the same level of assets today and that they invest equally in, say, land. Now assume that A receives a windfall gain with his land tripling in value while B’s stagnates. Most tax systems will treat A’s windfall gains very lightly, even though A is now considerably richer than B. It is improper for windfall gains to be taxed proportionately less than income from ordinary hard work.

The reality is that even as the rich continue to influence politicians to give them more and more exemptions, they end up suffering from the effects of the consequent regressive taxation regime. While they can own the best Mercedes, they must then hire heavily armed security guards and drive through sludgy, potholed roads. The quality of life is very low in societies that depend on regressive taxation.

Some other principles of taxation

Other principles of taxation include:

  • No taxation without representation (i.e. democratically determined taxes).
  • Inflation is the most regressive form of taxation. The liberal therefore opposes deficit financing except in the rarest circumstances (like war).
  • Taxes must be levied by that tier of government which administers the relevant service (principle of subsidiarity).
  • Since it is citizens who must be taxed, taxation of goods must be avoided, being limited to Pigovian taxes to facilitate the internalizing of negative externalities. Where possible, market-based instruments should be used to control negative externalities.
  • The variable cost of a government service to an individual or industry, such as the cost of processing a license, should be recovered from that individual or industry (cost recovery principle).
  • The government should not own land except for roads, common infrastructure, Parliament, courts, basic defence establishments, and police stations. This will allow land to be put to its most productive use. The government should therefore sell land and use these revenues to keep taxes low.
  • Transfers of assets from one generation to another should be treated seamlessly, thus ruling out inheritance taxes.

Clearly, the liberal is not utopian. He realizes that practical matters related to the ease of collection of taxes will influence the real tax system, even though unavoidable distortions will result. Thing like a mix of indirect and direct taxes; or the use of visible and not discounted future income and wealth; will therefore be unavoidable.

Implications for India

What does this mean for India? A few thoughts are outlined below.

1. India must raise its overall tax level from the current tax share currently of around 16 to 18 per cent of GDP to 25 per cent of GDP (compared with 33-50 per cent of GDP in the West). Note that merely raising taxes without reforming India’s governance model will not improve much. Therefore governance reforms of the sort advocated in my book, Breaking Free of Nehru (http://bfn.sabhlokcity.com/) must form the bedrock of reform in public finance.

2. The only defensible way to increase taxes is to broaden the base by requiring all Indian families to lodge annual income and wealth tax returns. Poverty elimination, a vitally necessary part of the liberal agenda, also depends critically on the information received from such returns (see my article in Freedom First, August 2009).

The result would be to increase the base of tax returns in India from 3 crores to around 67 crores.

3. Since abolishing company taxes will be impractical and create many complications, an alternative is to reduce company tax level in India to 25 per cent while requiring dividends paid to Indian investors to be franked through an imputation system: thus defaulting to an income tax system.

4. Apart from eliminating indirect taxes (already touched upon) most excise duties and taxes on products will, in due course, need to be abolished. Pigovian taxes, however, may well be needed on a few products.

5. Given that increases in asset prices continuously transfer significant amounts of wealth to the rich relative to the poor, land and capital gains taxes would need to be increased, aiming at the end of all these reforms for a (broadly) overall flat tax system in India from the current regressive one.

Given space constraints I have been able to present only a sketch of a theory of liberal taxation, but I trust that these two articles of mine will be found broadly reasonable by liberals everywhere.

Freedom Team of India

Once again I’d like to remind that FTI (http://freedomteam.in/) continues to look for leaders and seeks your active involvement and support.

ADDENDUM (RANDOM NOTES)

http://www.nytimes.com/2010/10/10/business/economy/10view.html

Dividend holders pay corporation taxes. Don't forget that! (i.e. my assessment of Warren Buffet is perhaps incorrect)

Comparing Income, Corporate, Capital Gains Tax Rates: 1916-2011 (excellent: from Visualising Economics)

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