Thursday, December 13, 2007

Kaushik Basu

"India's high growth should persist no matter who comes to power. But destabilisation can come from a growing inequality."

Kaushik Basu C. Marks Professor of International Studies and Professor of Economicsand Director, Center for Analytic Economics Department of Economics, Cornell University; Ithaca, NY,

December 15, 2 pm


Murali said...



Kaushik Basu
Department of Economics
Uris Hall
Cornell University
Tel: 607 255 2525; Fax: 607 255 2818
Home Page:
Date of Birth: 9 January 1952
Nationality: Indian (Permanent Resident: USA)
Marital Status: Married with two children
Current Position
Professor of Economics and Carl Marks Professor of International Studies, Department of
Economics, Cornell University
Director, Center for Analytic Economics, Cornell University
Director, Program on Comparative Economic Development, Cornell University
1969-72: B.A. (Hons) in Economics, St. Stephen's College, Delhi University
1972-74: M. Sc. (Econ) in Economics, London School of Economics.
1974-76: Ph.D. in Economics, the London School of Economics.
Tutor at the London School of Economics, 1975-77.
Reader in Economics at the Delhi School of Economics, 1978-85.
Visiting Associate Professor at CORE, Louvain-la-Neuve, Belgium, 1981-82.
Visiting Professor at the Centre d'economie mathematique et d'econometrie, Brussels, 1981-82.
Member, Institute for Advanced Study, Princeton, 1985-86.
Visiting Professor of Economics, Department of Economics, Princeton University, 1989-91.
Visiting Professor, Department of Economics, Stockholm University, Spring, 1993.
Distinguished Visitor, London School of Economics, Autumn, 1993.
Professor of Economics, Delhi School of Economics, 1985-94.
Visiting Fellow, Office of the Senior Vice President, Development Economics, World Bank, 1998-99
VKRV Rao Visiting Professor, ISEC, Bangalore, 2000-2002
Visiting Professor, Kennedy School of Government, Harvard University, 2000
Visiting Professor, Department of Economics, M.I.T., 2001-02
Visiting Professor, Department of Economics, Harvard University, 2004
Visiting Scientist, Indian Statistical Institute, New Delhi, 2007
Professor of Economics, Cornell University, 1994 - Present
C. Marks Professor, Cornell University, 1996 - Present
Awards and Honors
The National Mahalanobis Memorial Medal (1989) for contributions to economics.
Fellow of the Econometric Society, 1991- Present
CORE Fellow, 1981-82.
UGC-Prabhavananda Award for Economics, 1990, citing my work in theoretical development
VKRV Rao Distinguished Visitor at the Institute for Social and Economic Change, Bangalore,

Murali said...

Preliminary draft
The Sage-Madras School of Economics Lecture, 2007
delivered in Chennai, December 14, 2007
India’s Dilemmas:
The Political Economy of Policy-Making in a Globalized World

Kaushik Basu

Professor of Economics and C. Marks Professor of International Studies

Department of Economics


Director, Center for Analytical Economics

Cornell University

Uris Hall

Ithaca, New York 14853


1. Present Continuous to Simple Past

For the Indian economy this is the age of the present continuous. This is evident from a spate of recent books: India Arriving (Rafiq Dossani), Propelling India (2 volumes, Arvind Virmani), India: Emerging Power (Stephen Cohen), India’s Emerging Economy (the present author). If India does not arrive, emerge or get propelled, there will evidently be a lot of disappointed authors. What are the chances that these same verbs will apply to India in the not too distant a future, but in the past tense? This is a convenient question with which to begin this lecture. And for that we must start with the facts.

That the aggregate Indian economy is growing very rapidly is now beyond question. Having grown at around 1% per annum from 1900 to 1950, and at a sluggish 3.5% through the 1950s and 1960s, India’s growth rate suddenly picked up in the late seventies. From 1993 the economy was growing even faster. It seemed to be on a growth path of 6% per annum; and over the last four years the growth has been an astonishing 9%. This is clearly remarkable performance compared to India’s past, but how does it compare with other nations of the world? The answer is very well; and this can be illustrated by creating a league table of nations in terms of per capita incomes.

For this let us go back to 1975, the time when purchasing power parity (ppp)-corrected international data became widely available. If we take the 109 nations for which consistent data are available and track India’s movement through this chart, one can immediately see how the Indian economy has performed vis-à-vis other nations. 109 nations are, however, difficult to display on a page, so let me consider the poorest 52 nations among them. The rankings are presented in Table 1. In 1975 India had a rank of 90 among the 109 nations. In other words it was the 90th poorest nation. There were only 19 nations behind it. By 1984 it had a rank of 89, a small improvement. By 1994 it had moved up to rank 80, and by 2004 to rank 75. This is good performance but it is sobering to see China climbing from 108th rank the 58th over the same period.

Indeed, if we take the last decade and a half and do a global cross-country comparison, there turns out to be two nations in the world that had consistently higher growth than India. These are China by a wide margin, and Vietnam by a sliver. Pakistan, it is interesting to note, grew faster than India between 1975 to 1984, but after that it fell behind.

Table 1: Bottom 58 countries GDP/capita [PPP, 2000 international dollars]

Rank 1975 1984 1994 2004
58 Paraguay Dominican Republic Dominican Republic China
59 Tunisia Philippines Swaziland Peru
60 Dominican Republic Botswana Peru Swaziland
61 Guatemala El Salvador El Salvador El Salvador
62 Swaziland Guatemala Jordan Paraguay
63 Malaysia Ecuador Jamaica Jordan
64 Ecuador Jamaica Philippines Philippines
65 Belize St. Vinc./Grenadines Guyana Guyana
66 Zimbabwe Belize Guatemala Sri Lanka
67 Jordan Guyana Morocco Guatemala
68 Bolivia Thailand Ecuador Morocco
69 Morocco Morocco Nicaragua Egypt.
70 Syria Swaziland Syria Jamaica
71 Cote d'Ivoire Egypt Egypt. Ecuador
72 Papua New Guinea Syria Indonesia Nicaragua
73 Congo, Dem. Rep Cameroon Sri Lanka Syria
74 Honduras Zimbabwe Papua New Guinea Indonesia
75 St. Vinc/Grenadines Honduras Zimbabwe India
76 Thailand Bolivia Honduras Honduras
77 Ghana Sri Lanka China Georgia
78 Cameroon Papua New Guinea Solomon Islands Bolivia
79 Togo Cote d'Ivoire Bolivia Lesotho
80 Mauritania Solomon Islands India Papua New Guinea
81 Gambia Congo, Dem Rep. Pakistan Ghana
82 Central African Rep. Indonesia Ghana Pakistan
83 Botswana Gambia Cameroon Cameroon
84 Sri Lanka Togo Mauritania Chad
85 Senegal Mauritania Lesotho Zimbabwe
86 Egypt, Arab Rep. Senegal Gambia Gambia
87 Zambia Ghana Cote d'Ivoire Sudan
88 Madagascar Central African Rep. Togo Mauritania
89 Solomon Islands India Georgia Bangladesh
90 India Rwanda Senegal Solomon Islands
91 Sudan Pakistan Bangladesh Senegal
92 Indonesia Bangladesh Sudan Cote d'Ivoire
93 Niger Zambia Nepal Togo
94 Sierra Leone Sudan Central African Rep. Nepal
95 Chad Congo, Rep. Kenya Rwanda
96 Bangladesh China Congo, Dem. Rep Burkina Faso
97 Pakistan Sierra Leone Burkina Faso Nigeria
98 Kenya Kenya Guinea-Bissau Kenya
99 Rwanda Madagascar Chad Central African Rep.
100 Nigeria Benin Nigeria Benin
101 Guinea-Bissau Lesotho Benin Congo, Rep
102 Benin Nepal Madagascar Zambia
103 Nepal Burkina Faso Zambia Madagascar
104 Burkina Faso Niger Congo, Rep. Niger
105 Burundi Chad Sierra Leone Guinea-Bissau
106 Congo, Rep. Guinea-Bissau Burundi Congo, Dem. Rep.
107 Lesotho Burundi Niger Burundi
108 China Nigeria Rwanda Malawi
109 Malawi Malawi Malawi Sierra Leone

Source: World Development Indicators 2006. World Bank.
Just as the superior performance of the aggregate Indian economy is now beyond question, equally beyond question is the fact that inequality in India, no matter how one measures it, is growing. The outstanding average figures are being achieved largely by a small segment of the well-off population growing at phenomenal rates, the middle income group growing well but less rapidly and a bottom segment of around 20% of the nation growing at snail’s pace. What this suggests about poverty is true. Poverty, as measured by the percentage of people below the poverty line, is declining but at a rate that is unacceptably low. It is unpardonable that an economy that is doing so well overall has somewhere between 220 and 280 million people living below the poverty line. And it is important to remember that we draw our poverty line really low, which is a useful technique for keeping these numbers low.

I will return to the question of inequality and poverty later in the lecture; let us for now persist with the question of the prospects of overall growth. To understand this we need to know the sources of India’s rapid growth. Though ideologues will disagree, a dispassionate analysis shows, not surprisingly, that many factors lie behind this. One indicator of the multiplicity of causes is the fact that the economy has reached its current phase of high growth in several steps.

The question of when the first break in growth in independent India occurred has exercised many minds and as research has progressed we have gone further and further back: early 1990s, early 1980s and even late 1970s (see Dani Rodrik and Arvind Subramanian, 2004; Arvind Panagariya, 2004; Balakrishnan and Parameswaran, 2007; Kaushik Basu and Annemie Maertens, 2007; Kunal Sen, 2007). I would argue that the first of the growth spurts occurred in the year that most of us Indians block out from our psyche as non-existent—1975. In that first year of the Emergency the nation grew at 9% and it was not just a one-year spurt. Barring a severe downturn in 1979-80, when the economy shrank by 5.2% (the worst year in the history of independent India), the economy never looked back after 1975.

What caused this initial breakaway from stagnation is a matter of some debate, but one factor, which is undeniable, is that India’s savings and investment rates had risen sharply from the late sixties to the late seventies. What caused this? Clearly, the nationalization of banks in 1969, with the state-owned banks then being forced to open branches in remote areas of India, and the start of Unit Trust of India in 1964 were key factors in boosting the savings rate, which in turn was the first impetus for rapid growth. Data on the number of bank branches (see Basu and Maertens, 2007) indeed show a sharp rise after 1969.

The next step up in growth occurred in 1993 and the cause here was very different. The reforms of 1991-93, which led to the removal of India’s notorious licensing system, and effected a range of policy initiatives in the international sector, were arguably the most important policy event in India since 1947, and one can see its impact in the faster growth and the exponential build-up of foreign exchange reserves that happened subsequently. This is evident from Table 2. From 1977 to 1990 our foreign exchange reserves hovered around 5 billion dollars, occasionally dropping to a precarious low level and more occasionally crossing 6 billion dollars. From 1993 the reserves started rising, steadily and on a high gradient, and is now well over 200 billion dollars. The reforms of the early nineteen nineties were primarily concerned with India’s international sector and the success which India saw after that occurred primarily in the nation’s international dealings. Not only did the reserves build up but the precarious situation that we were in in the early nineteen nineties, with large short-term debt and unmanageably high debt-service ratio, rapidly abated. India’s exports picked up and the software boom was firmly on course (see Murthy, 2007).

Table 2: Foreign Exchange Reserves

Year Foreign Exchange

$ millions
Aggregate Export
Of Goods and Services

$ millions

Short-Term Debt,
As % of Forex Reserves

Debt-Service Ratio
1977 5,824
1990 5,834 18,477 129 35
1994 25,186 26,855 14 26
1998 32,490 34,298 16 18
2002 75,428 52,512 10 14
2005 130,000 83,500
2007 (early) 199,179 126,330

Source: Economic Survey (various), Ministry of Finance, Government of India; Reserve Bank of India; and Press Releases of the Ministry of Commerce.

Finally, let me turn to the last and most recent growth spurt that began four years ago and is continuing. Not surprisingly, since the analysts have not had time to catch up with the event, this is the least understood of India’s three growth surges. Among the chief causes of this latest surge there are three contenders that I would like to comment on.

1. The nation’s savings (and investment) rate, which is the critical driver of economic growth, has seen the most astonishing rise over the last four years, from 24% to 34% of the nation’s GDP, after remaining virtually stagnant since the late seventies. This places India, for the first time, among what was once thought of as an exclusively East Asian phenomenon--the ability to save and invest over 30% of the national income.

2. The last US presidential election caused a second outsourcing boom helping our economy greatly. During the election there was a lot of criticism of US firms that were outsourcing back office work to developing countries, India being the major destination. This had the unexpected effect of advertising the major cost-savings possible by outsourcing. Medium to small American firms that did not know about the profits to be made by outsourcing suddenly became aware of this. Advertising on US television is very expensive and Indian firms could never have financed this on their own. The advertisement effect of the debates on television during the last US election and subsequent attacks on outsourcing by some conservative television commentators have turned out to be an unexpected boon—someone else paying for your advertisements.

3. Finally, this is hard for me to prove since it is difficult to measure and quantify, but I believe there is a major cultural and social revolution on in India. For a market economy and, for that matter, any modern, industrial economy to function effectively requires a certain culture and a set of enabling social norms. The instinctive urge not to renege on contracts, the ability to restrain oneself from cheating to make small gains, having a culture of trust, and a multitude of other matters of habits and consuetude play a vital role in making a market economy possible. It is my belief that nations that have faltered on the path to industrialization--the sub-Saharan African nations, the South Asian economies, including India till recently, and many Latin American ones, have done so not because of large government (as the Chicago school would have us believe) or wrong fiscal or monetary policies as much as because the underlying structure of social norms and culture needed for an industrialized market economy were not in place.

This has important implications for often-heard counter-factual observations, such as “only if India had undertaken the reforms of the early nineties in the early fifties, we would not have lost forty years of growth”. We have plenty of examples of Latin American countries that opened early and were ravaged or, more accurately, savaged by global capital. Interacting with global corporations requires a certain amount of sophistication, without which it is easy to cut so many bad deals that one is left worse off in the end. It is difficult to know what an early opening up would have done to India, but it cannot be ruled out that we would have gone the route of so many banana republics that were ruined by this. One has to read accounts of native Americans doing “voluntary business” with the settlers and losing land in scandalous deals to understand what an unprepared launch into completely free-market transactions can do (Banner, 2007). Even recently India cut a very poor deal for power generation with Enron. And we were saved, only because Enron was ruined.

The exact link between culture and the economy is ill-understood though a recent literature on ‘trust games’—games in which, if two players can trust each other, they do very well, but, if one person betrays the other’s trust, then he does even better—is beginning to give us some vital clues about the connection between social variables such as trust and integrity and economic success.

A conjecture that I would like to maintain is that the success of the nineties and other factors that we may not even be aware of are now triggering a change in vital cultural variables that is giving this third growth surge an additional vitality. It is arguable that there is something common between higher savings and greater trustworthiness. Being trustworthy means foregoing small, immediate gains (the gain that one could make by letting down an investor, for instance) and achieving a greater return in the long run, because the reputation of trustworthiness means that more business and investment will come one’s way. Hence, greater trustworthiness is a counterpart of greater savings, which amounts to foregoing some current consumption to get even more consumption in the future. The latter is financial and the former social but they probably have the same fundamental root, a growing ability to wait, greater patience or, what we economists would describe as a lower time discount rate. So my conjecture is that in India there is a lowering of the discount rate that is occurring. This is resulting in higher savings which we can see and is well-documented and also improving trustworthiness and the culture of business, which we cannot formally document and so must be treated, for now, as conjecture.

The social and political infrastructure of business is still poor in India, as is easy to see from the World Bank’s new cross-country data on doing business in different nations, some of which are presented in Table 3 below.

Consider starting a new enterprise. To get all the requisite clearance will take 5 days in the US, 6 days in Singapore, 48 days in China and 71 days in India. Take contract enforcement, which is vital for the effective functioning of markets. To enforce a contract takes 69 days in Singapore, 241 days in China and 425 days in India. Even if you can start a business and have contracts enforced, the real catch is in closing a business. The time taken to close an insolvent business is 9 months in Singapore, 2 years in the US, 2.4 years in China and an epic 10 years in India.

To improve these requires changes in the law but also changes in institutions and the culture of governance. How the latter can be achieved is ill-understood. One reason for this is because economists treated culture and institutions dismissively in the past. But clearly the links between these and the economy hold vital clues to development and deserve much greater research initiatives.

Table 3. Nuts and Bolts of the Economy, 2005

No. of
Proce-dures to

Start Business

Time to
Start Business

Cost to


(% of Per

Capita Income)
No. of

to Enforce


Time to

Contracts (Days)

Time Closing a Business (Years) Difficulty of Firing Labor Index, 0-100
India 11 71 62 40 425 10 90
China 13 48 14 25 241 2.4 40
Hong Kong 5 11 3 16 211 1.1 0
Malaysia 9 30 21 31 300 2.3 10
U.S.A. 5 5 0.5 17 250 2 10
Singapore 6 6 1 23 69 0.8 0

Source: Doing Business 2006, World Bank, 2006.

To sum up, the infrastructure of norms and culture that enable enterprise and innovation and help build up an industrial society still has a long way to go in India, but my conjecture is that it has begun changing. On the financial and economic side savings and investment are up and on the international sector of India is doing very well.

These are trends that do not change too rapidly. Savings behavior and culture, for instance, do not change dramatically from one day to another (unlike share prices or the rate of inflation). Since international performance and savings are the bulwarks of India’s recent high growth, and, to the extent that the culture of the market is changing for the better, my expectation is that India is now in for a long phase of high growth. So the growth rate of between 8 and 10% per annum is, in all likelihood, here to stay for a few decades. And if this happens, a simple back-of-the envelope calculation shows that by 1930 India will have a per capita income of 20,000 dollars, which will place us in the category of industrialized nations. Even though a war or political instability can upset the scenario, this is not a forecast that can be dismissed out of hand.

Where I have greater doubts and believe we need to concentrate our energies and policies on is in matters of inequality and poverty. In distributing the spoils of the high growth we have done singularly badly. India’s income distribution is deteriorating and the bulk of the growth is occurring by a huge boost at the upper end of the income ladder (see Banerjee and Piketty, 2005; Bardhan) and the size of the population living below the poverty line remains embarrassingly large. These can of course become the cause of political instability and upset the aggregate growth scenario. But even if that were not to happen--the elite in India is quite good at the art of re-distributing just enough crumbs to the toiling masses keep insurgency at bay—such inequality and poverty are morally wrong in themselves and so we need to address them urgently.

2. Inequality and Poverty

What can be done about inequality and poverty is however a question that has different levels of complexity. There is a certain amount of direct action on the part of government that civil society must insist on. In these times of revenue buoyancy, government ought to divert more funds to directly supporting the poor—by ensuring that they have access to basic food, schooling and healthcare (Dreze and Sen, 2002). That India has lower literacy rates than several poorer sub-Saharan African nations speaks volumes about our government’s neglect of the poor. That malnutrition in the masses is rife speaks to the same neglect.

A lot can be achieved through direct budgetary provisioning, but a lot will still remain to be done; and what action can be taken beyond this is a difficult question, where politics and economics intertwine inextricably. We have seen this in the experience of West Bengal’s Left Front government. For nearly thirty years it took a tough line on industrialists—if you want to function in the state you have to pay workers good wages and offer good terms, the government insisted. This sounds unexceptionable but reflects a failure to understand realpolitik. In response to this the industrialists did not employ workers on better terms; they just did not employ workers. They left the state. What West Bengal saw over thirty years was a steady de-industrialization. Since agricultural growth cannot in the best of times match the high rates at which industry and services can grow, West Bengal lost out overall, despite its good agricultural performance. This mistake was realized four or five years ago. It was realized that one does not have to love capitalists to invite them to the state. It is a simple matter of choice. Do you have an option? The answer in today’s globalized world is no, and it is unfortunate that West Bengal took so long to recognize this. The Chinese recognized this in 1978. There has been a lot effort to make amends for this mistake, starting with the wooing of Tata’s small car project (the “ultra-affordables”) away from Uttranchal to Singur, in West Bengal.

There is no question that today the large corporations are getting a wonderful deal playing one government against another. But equally beyond question is the fact that there is very little else that each government can do. Not to attract capital is to doom your workers to poverty and unemployment. To attract capital is to contribute to growing global inequality. This is a problem that is afflicting not just poorer nations like India and China but also OECD nations. Thanks to inter-country competition to attract capital, there has been a steady erosion of the corporate tax rate in OECD countries. Inequality has been growing in China, India and the U.S., but also in the bastions of equality like Japan and the Scandinavian nations. This is a consequence of globalization.

How do we think about policy-making in such a world? I want to discuss some analytical tools for answering this question. At the root of the policy dilemma is the fact of a trade-off between inequality and poverty. In some contexts, a government is compelled to choose between greater inequality and greater poverty. In a poor nation when one faces such a choice, I believe one has to choose less poverty. So there are situations where one may have to live with a greater inequality to achieve not higher growth (I would consider that an unacceptable trade off) but less poverty.

The reason I place the qualifiers “in some contexts” and “there are situations” in italics is to emphasize that this claim must not be reduced to a license for tolerating any inequality. People often say that, though over the last two decades India’s inequality has risen a lot, poverty has declined, so that is fine. This is not what I am claiming, since there is no reason to believe that the lower poverty was made possible by the greater inequality.

To handle this policy quandary in a practical way, I would suggest a simple welfare criterion. We should judge a nation’s performance by the condition of the nation’s poorest 20% people. So instead of looking at the per capita income of the entire population of each nation and making inter-country comparisons (as most international organizations do), we should look at each nation’s per capita income of the bottom 20% of the population—I have elsewhere called this the ‘quintile income’—of the nation, and compare those (Basu, 2006; Subramanian, 2006, 2007). This entails a practical, policy-oriented formulation of John Rawls’ famous criterion of focussing on the primary goods consumption of the poorest person in society.

The quintile principle that I am suggesting here has several attractive features. It does not mean that one totally ignores the rich. If one did so and just tried to enhance the welfare of the poorest people, then the poorest people after some time will cease to be the poorest people. Some of the previously rich will now fall into this category replacing some of the previously poor. But since by the quintile principle the focus is always on the bottom quintile of society, focus will now automatically shift to the previously richer person who is now overtaken by the previously rich.

Second, the quintile principle does not ignore growth, but its focus is on the growth of income of the bottom quintile of society.

Basing policy on the quintile criterion leads some interesting insights into how to handle trade-offs between poverty and inequality and the special dilemmas that globalization give rise to. This is the subject matter of the next section.

3. Globalization, Poverty and Inequality

I shall in this section develop a simple, highly-stylized model to illustrate some of the principles discussed thus far. In particular, the model will illustrate (1) how the ‘quintile axiom’ may imply that we have to tolerate a modicum of inequality and (2) how globalization weakens each nation’s ability to control poverty and thus directs our attention to the need for inter-country coordination of policy.

Consider a world with ‘many’ identical countries. Each country has certain population. And of these people, half are ‘rich’ and half are ‘poor.’ What we mean by ‘rich’ and ‘poor’ is simply that in the absence of any government or community intervention, the rich are individuals who have an income of and the poor have an income of. Needless to add, is greater than, otherwise, my use of the words rich and poor would be rather alien.

Let us now introduce a minimal government into the picture. All this government does is to tax the rich and transfer that money as a direct subsidy to the poor. Suppose the government sets the tax rate at t. That is, a fraction t of the income of the rich is collected by government as tax. Let me denote the post-tax income (or disposable income) of the rich to be , the t in the bracket being a reminder that the post tax income depends on how high the tax is. Clearly, as t rises, will fall. This happens for two reasons. As more tax is taken away of course there will be less money in hand. But also, the fact that a part of one’s income is taken away may mean (at least in today’s world) that the rich will work less hard and so earn less to start with. A picture of a -curve is drawn in Figure 1. If people worked as hard as in a world of no taxes, then this line would decline as t rose but in a straight line and would be zero when t = 1, that is all one’s income is taxed away. In that case the -curve would be given by the downward-sloping straight line shown in the figure. Since we are assuming that taxes also discourage the rich from working as hard, their post-tax income is lower than the straight line and explains why takes the shape that it does in the figure. As shown, it is being assumed that when the tax rate reaches 9/10, the rich do not work at all. This is not a realistic assumption but a harmless simplification in the present context1.

Figure 1

What happens to the income of the poor once government steps in with the simple fiscal policy just described. In addition to their own income , they now receive transfers from government. Since the transfers depend on what is collected from the rich and is not dependent on what the income of the poor, we shall treat the latter as unchanged. Hence, when the tax rate imposed on the rich is t, the post-tax income of the poor, denoted by, is equal to plus whatever is collected as tax from each person (recall that for simplicity I assumed that the number of rich people is equal to the number of poor)2. This curve is depicted in Figure 8.2 by the inverted-U line. And the post-tax income graph of the rich is also shown in this figure. Basically, we now have in Figure 2 the post-tax (recall the tax is imposed only on the rich and the money is given to the poor) incomes of the rich and the poor. When the tax rate is 9/10, we assume the rich earn nothing. So the poor get no tax transfers and their income is back to , as shown in the figure.

Figure 2

In the light of the income scenarios that get created by the tax rate, as shown in Figure 2, the government will have to choose a tax rate that it will impose. That will surely depend on what the government’s objective or social welfare function is. Let us begin with a government that is ‘utilitarian’, in the sense that it is interested in maximizing the total national income without regard to who gets how much. Then clearly the tax rate will be set at 0. That will make the rich work the hardest and make the national cake as large as can be.

Next consider a government that is focused on the poor and wants to maximize quintile income as discussed above. This government will choose to set the tax rate at tQ as shown in the figure. At that tax rate, the income of the poor reaches the maximum it can3.

Finally, consider a government that is totally focused on inequality minimization. Such a government will set the tax rate at tE, as shown in the figure. At this point the rich and the poor earn the same amount. Notice however that to get to this point, the poor are made poorer. That is from a tax rate of tQ as we raise tax further and move to tE, equality rises but so does poverty since the poorest people become poorer. This is the sense in which poverty and inequality can entail trade-offs. I would take the view that in a situation like this, the inequality that occurs at tQ is worthwhile tolerating, because this is the inequality needed not to maximize growth but to maximize the well-being of the poorest sections. This is the idea of tolerable inequality discussed above.

It is worth clarifying that it is not always the case that the poverty minimizing tax will be less than the inequality minimizing tax, as shown in the figure. If this does not happen, then of course there is no quandary between poverty minimization and inequality minimization.

The shrinkage of policy space that occurs with globalization and also how globalization may contribute to greater inequality and greater poverty can also be illustrated using the above model. Let us now suppose that workers can choose to migrate from one nation to another and they choose to go where they have the highest earning. But when a worker decides to migrate, she needs permission (a work permit or visa) before she actually manages to migrate. I shall also assume that, if all countries have the same tax/subsidy rates, then each person stays in his or her home country. That is, when indifferent between migrating or not, a worker does not migrate.

In reality, with globalization, movement between nations can occur for corporations, goods and services. But since this is a very simple model with only labor, I assume that this is the only thing that can migrate. The instrument that governments have for attracting skilled labor is the tax rate. So what I am considering is a model of ‘real tax competition’ (Atkinson, 1999).

The problems of domestic policy in the event of globalization of the kind just described can be illustrated in many different ways. Let me here consider the case where each country aims to maximize its quintile income. In other words each country has a good government, genuinely concerned with raising the standard of living of its poorest citizens. If the boundaries of nations were exogenously closed (that is, there is no labor movement allowed), we have seen that each nation would set t = tQ, as shown in Figure 2.

Now, let globalization remove the exogenous hindrance to labor movements. Note that each country setting t = tQ is no longer an equilibrium. Suppose one country lowers t, clearly all productive people from other nations will want to migrate to this country. If the government now decides that it will (1) allow some of the rich people to come in and (2) not allow any poor person to come, it will clearly be able to increase the income subsidy-per capita that it gives to its poorest citizens. And for this reason it will be in each national government’s interest to cut tax rates a little. So tQ cannot prevail in equilibrium. To use the language of game theory, every government setting the tax rate at tQ is not a Nash equilibrium.

From the above analysis it should be evident that there is no tax rate t greater than 0 that will prevail in equilibrium. Because if all other nation’s are charging t, a government can lower tax a little, attract the rich and use the tax collection to subsidize the poor citizens of the nation. Hence, in equilibrium every country will set t = 0. Real tax competition in a globalized world results in the erosion of taxation; and in equilibrium we will have all rich and poor people earning as if there is no government. Each country ends up behaving as if it were interested in maximizing national income with no concern for poverty or equity. Globalization erodes each national government’s power to have equity-conscious policy. The mobility of labor (and, in a more realistic model, the mobility of capital) compromises a nation’s policy efficacy.

Evidently what we need is for the international coordination of anti-poverty policies. This is not to deny that re-distributive policies and more aggressive anti-poverty policies by individual governments are possible; and one must not let governments off the hook totally. But, at the same time, it has to be recognized that, as globalization progresses, there is increasing need for the coordination of policies across nations.

When we see the enormous poverty in Ethiopia or Tanzania, we tend to blame it on its government. While most governments have room to improve their performance, it would be wrong to overlook that how much control Ethiopia has over Ethiopian poverty or Tanzania has over Tanzanian poverty depends in part on what happens in Kenya, India, China and the United States. One sees this being played out within India. The state of West Bengal has had a democratically-elected, pro-labor government headed by the Communist Party of India (Marxists), for the last thirty years. On being elected thirty years ago, the government made it clear to the corporations and big industries that, if they did not give workers decent wages and provide reasonable working conditions, they could leave the state. This was a reasonable demand to make given how poorly Indian workers are paid. But the trouble was that, the workers of West Bengal did not get employment on better terms. They did not get employment. The region just faced de-industrialization. I do not think the aim of the government was wrong; it is their assessment of reality that was faulty. The same government is now wooing industry on terms that are lavish. In the current global situation, this is indeed the right thing to do. There is no other option. The need is to strive towards a major overhaul of global governance.


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