Non-cooperative Game: According to Kautilya, a trader was supposed to declare the price of his product at the city gate so that the tariff could be assessed correctly and collected before he was allowed to sell his product. He was concerned about the possibility of the government being cheated of taxes by the traders in certain circumstances, by understatement and in others by overstatement of the prices.
Tax Evasion by Understatement of Price: He seemed to refer to three prices: pG was the price declared by the merchant at the city gate, pw, the price the merchant was willing to accept (cost plus some reasonable profit), and pS the price at which sale was materialized. He (p 341) recommended a fine ‘Eight times the difference between actual and declared price’ for ‘declaring a lower price in order to pay less duty’ [ie. if pG < pW, penalty = 8(pW—pG) per unit].
Tax Evasion by Over-stating the price: According to Kautilya, the producer surplus should go the government. But he anticipated the possibility that a merchant might try to appropriate part of the potential producer surplus by overstating the price at the city gate. He (p 342) recommended that the penalty for ‘Calling out too high a price at the gate [anticipating competitive bidding] will be equal to the difference between actual sale price and the price originally called or double the duty (2.21).’ Thus, according to Kautilya, if the call price at the gate, pG > pw (and ps≥ pG), there would be a penalty equal to the difference between ps and pw. As an illustration, let me discuss this case. Suppose in anticipation of a strong demand for his product, a trader overstated the price, let t be the tax rate, λ, the penalty rate and Q, the quantity to be sold, then if not caught, he gained, Y = Q(1–t) (pG–pw). If caught he lost, X = Qλ(pG–pw). Suppose c is the cost of auditing, φ the probability of auditing and π the probability of cheating. The following payoff matrix may be used to express Kautilya’s ideas.
Matrix 12.1: Pay-offs (tax authority, merchant) Probability of cheating (π) Probability of detecting (φ) (X–c), (–X) Probability of not detecting (1–φ) (–Y), (Y)
Probability of not cheating (1–π) (–c), (0)
(0), (0)
By solving this, the probability of cheating, π = c/(X+Y) = c/[Q (λ+1–t) (pG–pw)], implying that it depends positively on the cost of detection and negatively on the penalty rate. The probability of detection, φ = Y/(X+Y) = (1–t)/(λ+1–t). It depends inversely on the penalty rate, implying that the tax authorities could save resources on detection by raising the penalty rate. For example, Kautilya specified λ =2, the tax rate, t= 0.2 and thus φ =0.286. The expected revenue of the government = π (X–c) + (1–π) (–c) = –cφ and the expected gain to the merchant = φ (–X) + (1–φ) Y = 0.
It is not claimed that Kautilya could calculate the values of φ and π. The only claim made is that he understood the non-cooperative nature of the relationship between the taxpayer and the tax authorities. The above analysis could be extended further.8
12.3 ANTICIPATION OF DUPUIT-LAFFER CURVE BY KAUTILYA Kautilya Curve: He believed that any tax rate lower than 1/6th would be insufficient in providing an adequate level of infrastructure which, in turn, meant a lower level of income, Y. According to him, initially, as tax rate increased, tax revenue increased, which allowed increases in the provision of public goods and, as a result productivity of factors of production increased. Infrastructure (building roads) opened up new markets for the existing products, created potential for division of labour and specialization and integrated segmented markets and broke up local monopolies, ie. the production possibility frontier shifted outwards. So, initially, as the tax rate increased the tax base also increased, consequently there would be a steep rise in revenue. That is, as the tax rate was increased, the tax revenue, R (t Y) increased more than proportionately to the increases in the tax rate. He (p 284) asserted, ‘He who causes loss of revenue swallows the king’s wealth (2.7).’
Similarly, Kautilya believed that any income tax rate higher than 1/6th would hurt private production. He (p 284) asserted (regarding the behavior of the tax collectors), He who produces double the [anticipated] revenue, eats up the janapada [the district; countryside and its people], by leaving them inadequate resources for survival and future production] (2.9).’ He (p 181) suggested for the king, ‘He shall protect agriculture from being harassed by (onerous) fines, taxes and demands of labour (2.1).’
The above statements imply that the revenue would start declining rapidly as the tax rate rose beyond the optimum rate due to: (i) a reduction in the growth rate of productive capacity of the private sector as the farmers would be left with very little to maintain productive capacity. (ii) Some individuals might migrate from the state. Nowadays too, individuals ‘vote with their feet’ and move to states with lower or no income taxes, and many corporations move to other countries with lower or no taxes (so called tax havens). (iii) Others might work less or revolt against the king or evade taxes (presumably, under a flat tax with no deductions and exemptions, there was perhaps, not much scope for tax avoidance through professional help!) Nowadays individuals may replace a government with their voting power. Not only was Kautilya against excessive taxation but also, as noted earlier, against collection before the due date (ie. before harvesting). The broken curve may be labeled as the Kautilya-Curve.9 According to him, the optimum tax rate should be 1/6th as was also traditionally held.
Spengler (1971, p 72) also remarks, ‘Kautilya’s discussion of taxation and expenditure, apparently in keeping with traditional doctrine, gave expression to three Indian principles: taxation power is limited; taxation should not be felt to be heavy or excessive; tax increases should be graduated. One of his main concerns seems to have been the collection and expenditure of revenue in such ways as to build up the permanent revenue-yielding capacity of the economy.’10
Spengler continues, ‘While he manifested little knowledge of tax shifting and incidence, he emphasized the long run, cautioned against too heavy taxation in the short run, and noted that a ruler could not tax at his pleasure, particularly in frontier regions whence disgruntled taxpayers could flee to neighbouring countries.’
Apparently, Kautilya did consider the distortionary effect of heavy taxation, although in a very limited sense that some taxpayers might move out of the state. However, his arguments were primarily directed towards the investment side: at initial stages of economic development,
Figure 12.2: The broken curve indicates Kautilya Curve whereas the solid curve is the Dupuit-Laffer Curve, t=1/6 is the optimal tax rate. provision of infrastructure increased the productivity of private inputs and consequently, level of output, but heavy taxation might starve private investment and adversely affect output.
12.4 VIEWS ON OTHER RELATED CONCEPTS Anticipation of the Concept of Producer Surplus by Kautilya: Initially, Marshall (p 811, fig. 39) was credited for originating the concepts of the consumer surplus and the producer surplus. However, later on when Dupuit’s work was discovered, along with Marshall, he was also given the credit for consumer surplus. Now Marshall may have to share the credit for producer surplus also – this time with Kautilya.
Capture of the Producer Surplus by the State: Kautilya (p 239) stated, ‘After the duty is paid, the merchant shall place himself near the customs house and declare the type, quantity and price of his goods. He shall call out for bids three times and sell to anyone who is willing to buy at the price demanded. If there is competition among buyers and a higher price is realized, the difference between the call price and the sale price along with the duty thereon shall go to the Treasury (2.21).’ Figure 12.3 may be used to capture his ideas.
As defined above, Ps = sales price and Pw = the price the seller is Figure 12.3: DD and D'D' are the demand curves, the shaded area represents the producer surplus, Ps = sales price and Pw = the price the seller is willing to accept and PWES indicates the supply curve such that Supply, Q = 0 if Ps
willing to accept (in this case Pw = PG). The supplier does not supply any amount of his product if he doe
s not get his call price, Pw, that is, supply is not a given constant. According to Kautilya, the difference between the sale price and the price the seller is willing to accept [ie. the producer surplus = the shaded area = (ps – pw)Qs] should go to the treasury.
Distinction between Current Account and Capital Account: He expanded the role of government from simple national defense and law and order to building infrastructure, providing relief to the public against natural disasters, fire and theft and taking care of the poor, sick and the old. He introduced other taxes and user fees to finance the additional functions. For example, he (p 177) asserted, The root of wealth is economic activity and lack of it brings material distress. In the absence of fruitful economic activity, both current prosperity and future growth are in danger of destruction (1.19).’
Accordingly, a significant portion of the revenue was directed towards productive activities. He (p 288) stated, ‘The [total] salary [bill] of the state shall be determined in accordance with the capacity [to pay] of the city and the countryside and shall be [about] one quarter of the revenue of the state (5.3).’ In other words, three fourths of the revenue was earmarked for capital formation.
SUMMARY Kautilya’s Arthashastra contains many essential ingredients of a sound fiscal structure, such as a linear income tax, stability of tax structure, maximization of net tax revenue, making tax payable at the right time and fiscal federalism.11 Despite the availability of a lump sum tax, he preferred levy of a linear income tax. Only recently, tax compliance has been incorporated into the discussion on optimal taxation but Kautilya proposed tax compliance as an integral part of a tax system. The concepts, at least in embryonic forms, of the Dupuit-Laffer Curve, and the Marshallian producer surplus were present in his analysis. He also provided a rare insight into the origin of an income tax and the institution of kingship. His observations are congruent with the new institutionalists’ approach. It is truly an independent piece of evidence since he could not have anticipated the debate between the new and the old institutionalists regarding the origin of institutions.
13
Kautilya on Famine and Freedom
In the interests of the prosperity of the country, a king should be diligent in foreseeing the possibility of calamities, try to avert them before they arise, overcome those which happen, remove all obstructions to economic activity and prevent loss of revenue to the state (8.4).
—Kautilya (4th Century BCE, p 116)
World food security became a major concern during 1972-1974. The World Food Conference of November 1974 was organized to handle the prevailing food crisis and to devise preventive and remedial measures to eliminate such threats forever. Unfortunately, no consensus was reached on undertaking any effective measures, perhaps due to divergence of national interests and lack of adequate understanding of the basic issues. Since then, apparently the world community has learnt a lot about the causes and consequences of famines and also has added some new terms, such as ‘entitlement’ and ‘FAD’ to its list of jargons. Despite such an understanding, so far only a weather-index-based insurance programme has been introduced and that too on a pilot basis and still there is no comprehensive plan in place. Consequently, world food security remains a major concern. There is a possibility that in the absence of adequate measures, more than a billion people might face starvation.
Actually, an adequate learning related to the causes and consequences of famines and devising of both preventive and remedial measures to deal with them had occurred more than two thousand years earlier. Book 8 of Kautilya’s Arthashastra contains five chapters, which specifically deal with managing systemic risk related to various natural and man-made calamities, adversities and vices. Building infrastructure, and provision of irrigation facilities for ensuring growth and stabilization of food production, and creation of buffer stock of food grains and its fair distribution were recommended for reducing the probability of a famine.
Kautilya wanted to create a prosperous and secure nation. He (p 121) described his ideal nation as: ‘It should be beautiful, being endowed with arable land, mines, timber forests, elephant forests, and good pastures rich in cattle. It should not depend [only on] rain for water. It should have good roads and waterways. It should have a productive economy, with a wide variety of commodities and the capacity to sustain a high level of taxation as well as a [large] army (6.1.8).’ Several salient features are worth mentioning. First, the statement ‘It should not depend [only on] rain for water’ emphasized the need for irrigation projects for reducing variability in agricultural output. Secondly, the statement ‘capacity to sustain a high level of taxation as well as a [large] army’ indicates that the economy must have the potential for generating an agricultural surplus for building infrastructure and maintaining strong defense. Thirdly, the statement ‘It should be beautiful, being endowed with arable land, mines, timber forests, elephant forests, and good pastures rich in cattle’ implies a diversified economy. Finally, ‘It should have good roads and waterways’ for facilitating commerce and fulfilling defense-related needs. Kautilya devised various policies to realize his vision of a strong and prosperous nation.
He approached each potential threat to the envisioned ideal nation very methodically and comprehensively. He tried to identify all possible sources of risk and rank them according to their seriousness. Section 13.1 contains his identification of natural disasters as potential risks and a comparative risk assessment analysis. According to him, in an agricultural economy, a drought had a devastating impact on the availability of work (ie. the livelihood of the people). His conceptual framework for handling risk arising from a drought is also presented in the same Section. His insights regarding the impact of famines on economic growth and freedom are presented in Section 13.2. Final section contains a few concluding observations.
13.1 KAUTILYA’S CONCEPTUAL FRAMEWORK FOR PREVENTION OF FAMINES Ranking of Natural Disasters according to their Impact: Kautilya ranked the seriousness of the various natural disasters. He first compared the relative seriousness of a drought to that of too much rain and concluded that drought was more serious. He (p 129) asserted, ‘a drought is worse than too much rain, because drought destroys livelihood (8.2)’. Then he compared the seriousness of floods to that of fire. He (p 131-132) added, ‘[Which of the divine calamities are more serious than others?] Some teachers say that fire is more serious than floods because destruction by fire is irremediable, consuming all; one can escape from floods and its damage can be alleviated. Kautilya, however, considers floods to be more dangerous because it destroys hundreds of villages while fire destroys [only] one village, or a part of it.’ He concluded floods to be more serious.
Then he proceeded to compare the seriousness of a famine to that of disease and epidemics. He argued, ‘Some teachers say that disease and epidemics are worse than famine, because pestilence brings all state activities to a stop with men falling ill and dying but during famine all work does not stop and it is still possible to collect revenue in gold or commodities or cattle. Kautilya disagrees. Pestilence usually devastates only a region of the country and remedies can be found for the disease. Famine, on the other hand, affects the whole country and deprives the people of their livelihood (8.4).’1 Kautilya argued that threat of a drought created a systemic risk since it affected the whole economy, whereas, fires, epidemics and floods did not create any systemic risk.
Foresightedness as a Critical Requirement for Risk Management: According to Kautilya, the king as well as his advisers should have the ‘ability to foresee things’. He described some desirable attributes of a king. He (p 119-120) wrote, ‘He should be just in rewarding and punishing. He should have the foresight to avail himself of the opportunities (by choosing) the right time, place and type of action (6.1).’ Similarly, he (p 120) described, ‘A councilor or minister of the highest rank should be a native of the state, born in a high family and controllable [by the king]. He should have been trained in all the arts and have logical ability to foresee things (1
.9).’
He provided a very broad definition of a calamity. He (p 122) wrote, ‘That which deprives (vyasyati) a person of his strength and goodness is a vyasana (a vice, adversity or calamity) (8.1.4).’ According to him, a king should take preventive and remedial measures to reduce the impact of a calamity. He (p 116) stated, ‘In the interests of the prosperity of the country, a king should be diligent in foreseeing the possibility of calamities, try to avert them before they arise, overcome those which happen, remove all obstructions to economic activity and prevent loss of revenue to the state (8.4).’
Preventive Measures: He emphasized investment on expansion of irrigation facilities and infrastructure. He (p 181) suggested, ‘Not only shall the king keep in good repair productive forests, elephant forests, reservoirs and mines created in the past, but also set up new mines, factories, forests [for timber and other produce], elephant forests and cattle herds [shall promote trade and commerce by setting up] market towns, ports and trade routes, both by land and water. He shall build storage reservoirs, [filling them] either from natural springs or water brought from elsewhere; or, he may provide help to those who build reservoirs by giving them land, building roads and channels or giving grants of timber and implements (2.1).’ He (p 553) stated, ‘A king makes progress by building forts, irrigation works or trade routes, creating new settlements, elephant forests or productive forests, or opening new mines (7.1).’
Importance of Irrigation in Reducing Variability in Output: He (p 619) stated, ‘As between land dependent on rain and land with flowing water [ie. a river], a smaller tract with flowing water is preferable to a larger drier one because with flowing water, which is always available, the production of crops is assured (7.11).’
Kautilya- the True Founder of Economics Page 23
