Use few tools for economic policymaking
When it comes to actual implementation, even big-bang reforms generally boil down to a series of steps on the tax front, in the subsidy regime, regulatory changes, or sundry other governmental interventions.
By Jaideep Mishra, |
NEW DELHI: Everything should be made as simple as possible, remarked Einstein, but not simpler! Consider the design of economic policy. A paper in economics, the open-access E-journal launched this month, uses techniques of experimental economics and modelling to show why reforms as a rule are marginal and piecemeal.
When it comes to actual implementation, even big-bang reforms generally boil down to a series of steps on the tax front, in the subsidy regime, regulatory changes, or sundry other governmental interventions. The multiplicity of policy instruments can lead to sub-optimal outcomes, the study finds. The upshot is that complex policy design is more likely to lower economic welfare and stultify performance. The implication for tax policy design, say, is to keep tax brackets limited to two, or three. The message? Simplify!
When it comes to tackling normative problems, that is tending to establish a norm in the very process of problem solving, the rationale for public policy is to chalk out optimal strategy to maximise social welfare. But in practice, the actual conduct of economic policy is not really about following stylised guidelines.
Given that the instruments of intervention are characterised by many parameters, precise optimality in policy design can only be an armchair exercise. When it comes to actual policy formulation, the way to go about it is to take a closer look at the set of policy parameters existing and then essay changing the status quo.
Also, since policy response to the current situation more often than not is to change a sub-set of the existing parameters, the net effect is marginal changes in the status quo. And given room for marginal improvements in the policy parameters, there ought to be enough scope for further reform.
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So far from the best-optimal policy being selected, what happens on the ground is that the economy stumbles into local optimums in a limited sense—to the extent that welfare gains can be brought about by small changes to a limited sub-set of parameters. The suggestion is that changes in the status quo are more a trial-and-error process. What the policy modelling implies is the strong influence of initial conditions on the follow through in policy decisions. If there is the real possibility of several local optima in policy design, which one actually gets selected would tend to depend on existing conditions. In other words, the resulting policy would be “history-dependent”. In effect, the more the number of local solutions in a given policy plane, the more likelihood of subjective and history-dependent policy outcomes. In the ideal world, of course, policy optimums would be quite independent of initial conditions.
Another implication of the experiment is that simple economic policy is preferable to a multiplicity of such tools. In the ideal world, increase in the number of policy instruments ought to be welcomed as it enlarges the scope of policy objectives that can be pursued.
But in a trial-and-error policy process, this may not necessarily hold. For in a situation of complexity, multiple instruments can very well mean several seemingly fitting policy solutions. It means much possibility of arbitrariness, history-dependency and lesser likelihood of beneficial policy outcome. Hence, the suggestion of simplicity in policy design.
In the modelling exercise, a study of optimal tax policy for “10 randomly selected economies” shows that those with complex tax systems are likely to end up with history-dependent, thoroughly sub-optimal tax structures. The study finds that the complexity of the tax system with a panoply of rules and exemptions affects its performance.
And further that reducing complexity with fewer tax brackets would bring about more optimality in policy design. Now in theory, increase in the number of tax brackets ought to increase welfare as old rates would only be replicated with the new tax code. But in practice, average performance of the tax system may worsen with complexity, as the taxes proposed may not be optimal to begin with.
The finding is that tax receipts are maximised with a no more than two or three tax slabs. Especially for indirect tax like Customs and excise what is needed is only a few tax rates to have transparency in taxation. Now that a pan-India goods and services VAT regime has been proposed for all and sundry indirect taxes, with taxes paid only on the value added, fewer rates would actually aid tax harmonisation.
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(The Complexity of Economic Policy, economics, Kiel Institute)
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