30 May 2017 19:47 IST

At what price point will people act?

The government must fix just the right tax or penalty rates to maximise gains without a social furore

One of the most fundamental concepts in economics is incentives — a set of rewards or penalties that nudges people to act one way or another.

Not all incentives need to centre on money. If your evening stroll happens to take you by the local bakery, the smell of delicious fresh bread is in the air and will incentivise you to buy not just a loaf but a few other goodies too.

Companies have been trying to optimise the price of their products from the time the barter system of trade transitioned to commerce using currencies.

Some buyers are motivated by low prices all the time. The promise for the customer is that he does not have to shop around, knowing well that he will always get a good deal. The catch is in the word, “Always”. Competitors can undercut the low price merchant by even lower prices, causing a downward spiral that can seem unstoppable. During the heydays of internet commerce in India a few years ago, e-tailers, flush with investor cash, discounted products to at or below cost. This strategy is clearly not sustainable as can be seen today.

The Goldilocks zone

The government too is in the business of determining the right price point at which gains are maximised without causing a social furore.

Consider the example of direct tax rates. If the income-tax rate is zero, the government gets zero revenue. If the income tax rate is 100 per cent, again, the government gets zero revenue because people have no incentive to work and will not generate any income.

So what should be the tax rate which, like the temperature of Goldilocks’ porridge in the kindergarten story, is not too low, not too high and is just right? At what tax rate would people be willing to share a part of their income to help fund government? At what tax rate will people not begin to hide income and cheat? At what tax rate will people not go to extreme lengths to suppress income, by hiring tax lawyers and accountants?

This is not an easy question. Common sense tells us that the tax rates have to be lower rather than higher because punishing citizens by heavy taxation will cause them to work less. But more socialist-styled governments — the Nordic countries, most of Western Europe and Canada — keep tax rates high, sometimes exceeding 50 per cent of income, but kick back generous social services such as free universal healthcare and education. These governments also believe in a fairness doctrine — that the rich should pay more direct taxes than the poor — although, progressive taxation only applies to income, and not to indirect taxes (like sales or excise).

Differentiated by paying capacity

If you’re a consumer, everyone pays the same tax rate, rich or poor. If a product is exempt from GST, for example, the exemption applies to everyone, rich or poor. Governments would like to make indirect taxes progressive too — wouldn’t it be nice to have a rich person pay more for a good than a poorer person? And indeed, the way this is done is by identifying the product that is being consumed and levying a higher tax on it. So, air-conditioners are taxed more heavily that school bags — the idea being that people with moderate income do not have the means to buy or maintain an air-conditioner.

Taxes are one thing but what about fines and penalties? What rates of fines would be appropriate? This is an easier question to answer — and, like taxes, fines have to be meaningfully low, relative to the violation committed. But unlike indirect taxes, fines unfortunately cannot be progressive — it would be unthinkable in modern society to penalise two individuals with different fines simply because one has a superior ability over the other to pay the fine.

If the traffic fine for not wearing a helmet is just ₹10, the penalty will not improve civic behaviour one bit. People will conclude that the fine is so low that they will simply pay up the fine and continue on with life. If the fine is ₹100 or ₹200, the fine will probably sting but still not strongly enough. It has a chance to modify behaviour although laggards and people habitually predisposed to disrespecting the law would chance violating it rather than change.

Price point for fines

So, what would happen if the government imposed a draconian fine? Say ₹10,000 for a helmet violation? With retail corruption at the lower levels of the police hierarchy so rampant in a country like ours, such a move would be highly ineffective, if viewed through an economist’s lens. People who are caught will simply bribe their way out of paying the fine. The government loses revenue; civic behaviour will remain unchanged and corruption increases — a triple whammy of unintended negative consequences.

Yet, our civic leaders in Bengaluru have decided to implement a policy precisely as poorly thought out as this. As reported in a recent story in BusinessLine, City Police Commissioner Praveen Sood, addressing a Bangalore Chamber of Industry and Commerce (BCIC) delegation of top industry executives at the Traffic Management Centre, said: “This is the only way we can bring in some sense of traffic discipline among vehicle users. Since the fine is substantial, vehicle users will think twice before violating traffic rules.”

Really, Commissioner Sood? Only way? What planet, pray, are you living on?

“We are not here to create awareness on traffic rules among users as these are pretty well-known to everyone. We are trying to get vehicle users to get into the self-regulation mode, thereby reducing accidents and easing traffic movements in the city,” he said.

Good luck with that one, Mr. Sood. Just be forewarned: Hope, as a strategy, never works. Ever.