The Keynesian school of economics dominated the debate during the period of crisis but Keynesian spending can be dangerous since it produces imbalanced budgets.
A variant of Keynesian theory is now available from the studies of Christina Romer and David Romer. Analysing the federal tax legislation in the US over 1945-2007, the Romers have drawn conclusions about the effects of changes in the level of taxation on consumption, short-term fluctuations, long-run growth, government spending and other aggregate outcomes. Their most striking finding is that exogenous tax increases have a large, rapid and highly statistically negative effect on output. The exogenous tax increase of 1% GDP lowers real GDP by almost 3%. Investment falls sharply in response to such tax increases. Tax policy has a powerful influence on economic activity. Comparing the effects of deficit-financed spending, deficit-financed tax cuts and tax-financed spending, the Mountford Paper of December 2008 concludes that ?deficit financed tax cuts work best among these three scenarios to improve GDP.? Successful stimulus relies more on tax cuts than on spending.
In India, policymakers always swore by fiscal spending rather than tax changes as an instrument of policy. It was only in the late 1990s that tax cuts assumed importance in the Indian fiscal scenario. Tax exemptions are of different kinds. Area based exemptions have helped in the development of industries in hilly areas. Backward area concessions and the promotion of SEZs have contributed their mite to economic development in specified areas. The giant stature attained by the LIC owes much to the tax incentives provided for investment in that institution.
It is only in the past three years that government appears to have rethought tax exemptions with a focus on zero tax companies. In light of recent studies, there is a lot to be said in favour of the view that tax policy by way of preferential treatment for backward areas and specified industries should continue to guide our policy in preference to deficit financing.
The author is a former chief commissioner of Income Tax and ex-member of the Income Tax Appellate Tribunal