The IMF prescribed severe austerity and economic shrinkage. You chaps have been living beyond your means for years, it said, and have severe structural problems that cannot be reflated away. So, you need bitter monetary medicine (sky-high interest rates) and fiscal medicine (slashing government spending and fiscal deficits). Yes, the shrinkage of GDP will be painful, but will cure your structural ailments and improve your long-term health. Ten years later we have another financial crisis, originating this time in the US. But the IMF, which prescribed austerity for Asia in 1997, is prescribing fiscal and monetary stimulation in the US, to save it from the consequences of its own follies. This is not only bad economics but also outrageous politics. It looks like a double standard that discriminates against the poor. The US has for a decade indulged in chronic overspending, reflected in gargantuan trade deficits, financed by borrowing overseas. This has eerie similarities with south-east Asia’s over-borrowing in the 1990s. The Asian financial crisis began with the bursting of a housing bubble in Thailand, caused by imprudent lending. The current crisis has begun with the bursting of a housing bubble in the US, also caused by imprudent lending (sub-prime mortgages). Conditions in the US are in most ways better but in some ways worse than in Asia in 1997. The US is immensely creditworthy, and can borrow trillions with minimal effects on the dollar. By contrast, south-east Asian economies in 1997 had low forex reserves and eroding credibility, leading to a panicky flight of investors. The US has huge foreign assets to offset its rising debt, so its net debt is modest. The quality of US institutions, financial markets, corporate governance and accounting standards is infinitely higher than in Asia in 1997. So, we don’t see any panicky exit of investors from the US. Yet, in some ways the US is structurally worse off than Asia in 1997. Asian economies always had high savings rates. But US households have for years had a negative savings rate — that is, they spend more than their disposable income, taking advantage of cheap, easy credit. The US trade deficit of around $700 billion per year is mind-boggling, far higher than the combined deficits of the Asian countries that sank in 1997. A country as rich as the US can afford to overspend on this scale for years. But not even the US can do this forever. The US has a deep structural problem — grossly inadequate savings. Its politicians are as spendthrift as households. They have committed themselves to high welfare spending on social security (for retirees), Medicare (for the aged) and Medicaid (for the poor). Some projections suggest that such spending could triple from 7% of GDP today to 20% by 2030. So, both US households and the government are on an unsustainable spending spree. This cries out for structural adjustment. Huge US imbalances, in its balance of payments as well as savings, have to be pruned. This painful structural adjustment is not urgent, given US riches. But it is inescapable in the long run, and remedial action is overdue. The adjustment can take place either through a huge depression, as in the 1930s, or through a series of slowdowns-cum-mild recessions. Many economists — including me — would regard a string of mild recessions as less damaging for the US and world economy than another Great Depression. Seen in this light, a US recession is a solution to its structural imbalances, not a problem. A recession will reduce the US trade deficit, and drive home to US households the need to save more and borrow less. It will entail some pain. But, as the IMF is fond of saying, no pain means no gain. Global imbalances are evident in huge Chinese and OPEC surpluses, no less than in US deficits. All three require adjustment. But the US is currently in crisis, and needs adjustment foremost. You might think that the IMF today would be urging austerity and structural adjustment on the US, as it did on Asia in 1997. In fact, it is doing the very opposite. It has applauded the fiscal stimulus legislation and slashing of interest rates there. The IMF can argue, rightly, that the two situations are different. Yet, there are enough similarities to warrant complaints that it has one rule for the rich and another for the poor. I raised this issue of double standards when Dominique Strauss-Kahn, managing director of the IMF, gave a talk in New Delhi last week. If austerity was good for imprudent Asians in 1997, i asked, isn’t it also good for the imprudent US right now? Should you not welcome a recession as a form of adjustment? Should you not burst asset bubbles in the US rather than reflate them? Strauss-Kahn waffled and refused to give a straight answer. Instead, he talked of the need to reform the IMF, by giving a bigger say to developing countries. However, his double standards suggest that the reform has to go deeper. ——————— Paying record taxes is bliss 10 Feb 2008, 0000 hrs IST,Swaminathan S Anklesaria Aiyar Print Save EMail Write to Editor Socialists love to soak the rich. They loved Indira Gandhi\’s garibi hatao socialism in the 1970s, which raised the peak income tax rate to 97.75%, along with a stiff wealth tax. At one post-budget press conference, I asked what was the maximum a rich person could earn after honestly paying taxes. An official replied that, assuming a rich person\’s assets yielded 7% (which at the time was the yield on national savings certificates), then the maximum he could earn after taxes, no matter how great his assets, was just Rs 25,000 a year! In theory, this should have ushered in a socialist paradise. In practice, it converted India into a massive black economy. Businessmen faced the choice of honestly going bankrupt or dishonestly concealing income. No prizes for guessing which path they chose. Actual collections of income and corporate tax in 1970-71 totalled Rs 780 crore, just 1.8% of GDP. Economic liberalisation cut the top income tax rate in stages from 56% in 1991 to 30% in 1997. Leftists said this was enriching the rich. Actually, the rich started paying much more. Payments of direct taxes rose sharply, from 2.4% of GDP in 1990-91 to 3.6% in 2000-01. But even this paled before the huge upsurge after 2004. For 2007-08, the budget projected income and corporate tax of 6.2% of GDP. Actual collections have exceeded expectations so far, and the final figure may be a whopping Rs 300,000 crore, or 7% of GDP. So, the rich have flooded the government\’s coffers as never before. Few countries in history have experienced such a huge upsurge. What accounts for it? Lower tax rates are only part of the story. Obviously people are more willing to pay taxes at lower than higher rates. But, as our table shows, lower tax rates in the 1990s yielded good improvements, but not the bonanza of the last few years. Indeed, the recent imposition of a surcharge and cess means that the peak rate of income tax has actually risen, from 30% in 1997 to almost 34% today. Yet, tax collections have skyrocketed. So, lower tax rates after 1990 are only a small part of the story. A bigger part of the story is the abolition of wealth tax on shares in 1993. During the garibi hatao days, a company that declared good profits raised its share price, and hence raised the wealth tax that its promoter had to pay. Extortionate income tax rates made savings from white money impossible. So, promoters had to sell their shares to pay wealth tax. They were doomed to extinction if they kept profits on the books. Naturally, they found a thousand ways of keeping profits off their books, depressing share prices and their wealth tax liability. The abolition of wealth tax on shares in 1992-93 attracted little public attention since actual collections of wealth tax were small. Yet, this single measure suddenly made it possible for businessmen to keep profits on the books and improve shareholder value. Keeping profits on the books meant paying more corporate tax, of course, but it also carried the reward of higher share prices, without the penalty of wealth tax. The immediate impact on tax collections was significant but not revolutionary. Many businessmen were reluctant to declare all profits honestly, in case reforms were suddenly reversed (as seemed entirely possible at the time). The tax administration was so weak and corrupt that tax evasion carried little risk. This situation changed with the computerisation of banks and tax records. This led to Tax Information Networking (TIN) after 2001, enabling tax authorities to trace transactions and ask uncomfortable questions. Stronger tax administration made tax evasion more risky, and thus helped improved tax honesty further. The clincher was the boom in the stock markets and IPOs (initial public offers) of shares in the mid-2000s. Companies raised money for expansion by issuing new shares to the investing public at ever-higher prices. The price they could ask was typically a multiple of their profits. So, the higher the profits they showed in their books, the higher was their sale price. For the first time, business honesty became massively profitable. Finally, GDP growth accelerated from 6.2% in the 1990s to 8.7% in the last four years. This yielded a boom in corporate profits and hence corporate taxes. The lessons are clear. Extortionate tax rates hit honesty, not riches. Cutting tax rates by itself will not produce honesty: you need a stick (the TIN system) as well as carrots (lower tax rates). Finally, you need a booming stock market to convert tax honesty into a profitable launch-pad for high-priced share sales. This combination has now produced a tax bonanza of 7% of GDP. This is not soaking the rich. Rather, it is a system where the rich have the right incentives to share their prosperity with the tax authorities in the hope of getting richer still. Direct tax collections of Rs 300,000 crore can finance massive rural infrastructure, skill development anti-poverty schemes. This will reduce poverty far more than the garibi hatao tactics of the 1970s.