Immediately after the Direct Taxes Code Bill was introduced in Parliament, our revenue secretary told the press that the moderation of taxes along with concessions would result in a revenue loss of Rs 53,172 crore in 2012-13 if the present rates were to be applied. The gross tax revenue from direct taxes would come down from about Rs 5.80 lakh crore to Rs 5.27 lakh crore under the proposed code. These estimates should come as a surprise. Both Mr Pranab Mukherjee and his predecessor had sworn by the theory that reduced tax rates would produce better compliance. The present FM had pointed to the way the high tax regime of the 1970s gave way to lower taxes producing a better yield of tax revenues. He also believes that loss on account of concessions through lower taxation would be made up through better compliance.

The idea that lowering the tax rates will lead to better revenue mobilisation was first popularised by the American economist Arthur Laffer and writer Jude Wanniski in the 1970s and 80s. Tax rates of 0% produce no revenue. Rates of 100% should also produce no revenue; no one would bother making the money that falls into the government coffers. Thus, there is some rate in between the two that maximises revenue. This is represented by the Laffer curve. In graph 1, at point A in the curve where taxes are not quite 100%, people will find it to their benefit to take some of their incomes in taxable wages. At point B, the economy hums along with unfettered high production but because tax rates are low, the government gets the same small amount it would get if taxes were at A. It is at point E that the tax rate maximises government revenue. If taxes fall below E, it may stimulate production but it obviously diminishes government revenue. E is by definition the point of maximum revenue. Revenue will fall if the rates rise above E. This is quintessential supply-side economics. The theory will make sense if lower tax rates help people to make more investments. Firms may have incentives to invest and cast the supply curve to shift outwards to the right.

The American government under Reagan experimented with the Laffer theory. Research by British fiscal pundits appeared to indicate that the latest 50% rate for non-domiciles may not be all that welcome. Using figures from the 1970s when the top tax rate was 83% and contrasting the same with the current figures with top rate of 40%, supply-side economists have shown that the top earners now pay a far higher percentage of all income tax revenue than was the case in 1978-79. As against 5% of earners paying 24% of income tax then, they now pay 43%?thereby proving that a higher tax rate will generate a lower tax revenue for the government.

The Laffer theory has been disputed since its very inception. Writing in a scientific journal, an ace mathematician?the late Professor Martin Gardener?considered the Laffer curve too simple to be of any service, except as a symbol of the concept. Modern economies are dominated by the complexities of what Professor Galbraith designated as the ?Techno-Structure?. Professor Gardner devised the new Laffer Curve (see graph 2). As the curve moves into the complexities of the real world, it enters into what Professor Gardener calls the ?Techno Snarl?. There may be several values for the tax rates, thus producing multiple points ?E? on the ?Techno Snarl?. More than one tax rate can maximise government revenue. At some intersection point, lowering tax from a given tax rate will lower revenues. At other points for the same tax rates, it will raise revenues. It is not possible to lay down any hard and fast rule on the sort of fiscal and monetary policy that would move the economy fastest along the curve to the nearest point E. No wonder, Professor Galbraith called the Laffer theory, ?A relatively sophisticated form of fraud? and George Bush called it Voodoo economics.

For the past 10 years, individual tax rates in India have remained at 10%, 20% and 30%, with marginal adjustments of the lowest slab for inflation. DTC maintains these rates. Corporate tax is set to be lowered to 30% from 33.3%. If the Laffer effect is true, tax revenues should go up with projections of GDP growth at 8.6%. Tax collection has always been showing an upward trend from 9.4% of GDP in 2004-05 to 12% in 2007-08. Global recession affected the revenue growth subsequently. The decline was perceptible, being 10.9% in 2008-09 and 10.3 % in 2009-10. These figures do not bear out the correctness of the Laffer theory. Nor is the projected estimate of a fall in tax revenues in 2012-13 justifiable. If the Laffer theory is right, countries like the US, the UK and Australia will not have such high rates of tax like 35%, 40% and 45%, respectively. Japan has the highest personal income tax rate of 50%.

Laffer or no Laffer, we need to reduce our tax rate so as to increase our international tax competitiveness. A tax rate cut will boost our attractiveness as a location for international investment. Second, it is no longer true that the burden of direct taxes cannot be shifted. The cost of these taxes can be passed on by way of lower returns for shareholders, as for example, the unit holders of mutual funds will have to bear a tax of 5% from 2012-13 onwards. Third, higher taxes can also mean higher prices for customers and lower compensation for employees.

Spiralling inflation will certainly boost revenue collections but the middle-class taxpayers do need relief by way of permanent adjustment of slabs.

The author is a former Chief Commissioner of Income Tax and ex-member of the Income Tax Appellate Tribunal