He also recommended an indirect method of investigation. He (p 742) wrote, ‘Any official who incurs the displeasure of the people shall either be removed from his post or transferred to a dangerous region (13.5).’21 He believed, employees, if not inspected, might shirk work. He was aware of the need for inspections and payment of efficiency wages to elicit effort. However, it is not claimed that Kautilya could trace the efficiency frontier between efficiency wages and the probability of inspection. The Arthashastra does not contain any theoretical models (as we know them) to determine their optimum levels. Usually, too much emphasis is put on variability in an employee’s pay but, according to Kautilya, a safe working environment was equally important.
Reward for Extra and Better Work by the Piece-rate Workers: Kautilya was aware of the fact that piece-rate workers paid less attention to quality. He recommended extra payments as an incentive to these workers so that they made products of better quality and also worked on holidays. He (p 233) suggested, ‘For better work [or greater productivity], women who spin shall be given oil and myrobalan cakes as a special favor. They shall be induced to work on festive days [and holidays] by giving them gifts. Weavers, specializing in weaving any fabrics of flax, dukula, silk yarn, deer wool and [fine] cotton shall be given gifts of perfumes, flowers and similar presents of encouragement (2.23).’
Tournaments: Nowadays, the vice presidents in a corporation are supposed to compete hard to reach to the top of the ladder and enjoy the status, salary, leisure and perks accompanying the promotion. The idea of a tournament and the winner being awarded a prize as an incentive to extract maximum effort was very much alive during Kautilya’s time (Olympics started around 776 BCE) too. He (p 714) suggested, ‘The Chief of Defense shall make the troops happy with wealth and honors and announce the following rewards—a hundred thousand panas for killing the enemy king, fifty thousand for a prince or the Army Chief, ten thousand for a division chief, five thousand for an elephant or chariot warrior, thousand for a horse, one hundred for an infantry section leader, twenty for a soldier, as well as double normal wages and whatever booty they seize (10.3).’ It may again be noted that both profit sharing and the winner receiving a prize were common practices to induce effort. Clearly, the concept of tournament originated in a different context but the objective was the same: to make participants compete hard for the prize. However, as noted above, not only were material incentives offered but also an equal attention [was] paid to moral incentives to maintain and strengthen motivation.
Reducing Distractions: There were enough distractions in Kautilya’s times to warrant his attention to modes of reducing them.22 He (p 180) wrote, ‘There shall be no grounds or buildings intended for recreation [in the new settlements]. Actors, dancers, singers, musicians, professional story-tellers and minstrels shall not obstruct the work [of the people], because in villages which provide no shelter [to outsiders], the people will be [fully] involved in the work of the fields. [Consequently] there will be an increase in the supply of labour, money, commodities, grains and liquid products (2.1).’
Punishments: Kautilya recommended severe and certain statutory punishments (normally monetary) for mismanagement and corruption. According to him, the magnitude of punishment should vary with the nature and severity of [the] mismanagement, that is, whether it was due to ignorance, laziness, timidity, corruption, short temper, arrogance or greed of the official. He (p 283) observed, ‘Those officials who have amassed money [wrongfully] shall be made to pay it back; they shall [then] be transferred to other jobs where they will not be tempted to misappropriate and be made to disgorge again what they had eaten (2.9)’. He (p 284) continued, ‘An officer negligent or remiss in his work shall be fined double his wages and the expenses incurred (2.9).’
11.4 PAYMENT-SYSTEM DESIGN TO ALLEVIATE MORAL HAZARD Kautilya understood the importance of contract designs, which could eliminate the ‘moral hazard’ problem in certain situations. Even in an agrarian economy, at least some moderately complex situations could arise. He observed at least two such situations and provided some insights, which may be relevant even for modern corporations.23 He emphasized the sanctity of contracts. He (p 450) recommended, ‘The agreement between a labourer and the one hiring him shall be made in public. Labourers shall be paid wages as agreed upon. If there is no prior agreement, the labourer shall be paid in accordance with the nature of the work and the time spent on it at customary rates (3.13).’ He believed that contracts made in public were verifiable and, therefore, enforceable. He indicated that the customary rate was one-tenth of the produce but [he] modified this customary practice in two cases.
Case (a): He (p 317) recommended, ‘they (a herdsman, milker, a churner and a hunter-guard) shall be paid in cash, because if they are paid in milk or butter oil, they will starve the calves to death [by milking the cows dry, leaving nothing for the calves] (2.29).’ This may be made explicit as follows. Let X be the total milk output, which a cow produced and θX, be the calf ’s share. If the agent (a herdsman, milker, churner or a hunter-guard) was paid in kind as a share, α of the output, (1–θ) X left after providing for the calf [ie. his share would be α (1–θ) X]. The agent would try to maximize his utility V. Clearly, θ, the calf ’s share was under his control. He would maximize the following:
Max V [ α (1–θ) X]
Maximizing with respect to θ
dV/dθ = –V’α X < 0. That means the agent would set θ = 0.
That is, he would not leave anything for the calf and essentially his wage would be αX. The principal would not know how much milk the calf was getting. Certainly, he could look at the health of the calf and fire the agent if it did not look healthy. But the next agent would do the same thing because there was a built-in incentive to starve the calf. It implies that the agent had to be paid a cash wage equal to or higher than αX. The principal (the king) was interested in maximizing the total output, X and also its efficient allocation between current consumption, (1–θ) X, and investment, θX (which was calf ’s share) and Kautilya recommended θ to be decided by the principal and the agent should have no stake in it.
Two observations are in order. First, in terms of a modern corporation, a determination of θ essentially amounts to the allocation of profit between retained earnings and dividends. At present, this decision is made by the management (the agent) and not by the shareholders (principal). Accordingly the shareholders have to search for the stocks, which match their preferences related to growth and income. According to Kautilya, the shareholders themselves should be allowed to decide θ. Particularly, the institutional investors perhaps wouldn’t mind making this decision. Anyhow, its feasibility and efficiency deserve exploration.
Secondly, it is a very simple example but carries a profound idea— [the need] to recognize and resolve the ‘moral hazard’ problem. The milkman had an incentive to squeeze the calf and thus could hurt the growth of livestock and subvert the objective of the principal. Similarly, the CEO of a modern corporation may resort to squeezing both the workers, and the stockholders (with or without the provision of stock options) to advance his own interest. For example, the stock options have made super magicians out of the CEOS and CFOs, who have been producing eggs out of thin air and getting rich by hatching them. The point is that stock options alone, even if they are included in the expenses, cannot be the solution to the principal-agent problem.
Case (b): Kautilya (p 288) stated, ‘If the [amount of actual cash in the] treasury is inadequate, salaries may be paid [partly] in forest produce, cattle or land, supplemented by a little money. However, in the case of settlement of virgin lands, all salaries shall be paid in cash; no land shall be allotted [as part of the salary] until the affairs of the [new] village are fully stabilized (5.3).’ Obviously, supervising the settlement of virgin lands was a full time job. If the officers were allowed to work on the land, they might spend very little time on the official duties and disproportionately more time working on the land, that is, ignore their pr
imary responsibilities. This observation also has a direct implication for modern corporations. The part-time Directors of corporations are really no matches to the sophistication of the fulltime CEOs and CFOs, some of whom have been busy cooking the books (see Chapter 9), or to the complexities of the modern businesses. It is obvious that the current system of corporate governance cannot guarantee either accountability or transparency.
Wage Payment System versus Sharecropping: Recently, Robert Gibbons (1998) notes that the trade-off between insurance and incentives may be captured by the work of Lee Alston and Robert Higgs (1982) on sharecropping. According to them, there were three kinds of contracts. If the output, y, depends on effort of the agent and there is some uncertainty, ε, y= a + ε, and the agent is paid a wage w such that w= s + b y. If (i) b=0, then the worker is paid a cash wage, (ii) if 0 < b <1, the worker shares the risk and (iii) if b=1, the worker assumes all the risk and pays rent to the land owner. Kautilya emphasized that land should belong to the tiller and thus the case (iii) in general had no place in his scheme, that is, absentee landlords contracting out their pieces of land for a rent was not recommended.
Irrigation and Sharecropping: Sharecropping implies sharing both the return and the risk. But the presence of risk creates a disincentive to a risk-averse agent.24 However, if there is an input, which reduces risk and also increases expected return, a risk-averse agent is likely to be encouraged to use such an input even under a sharing arrangement (ie. sharecropping or profit sharing system). For example, irrigation leads to a higher yield and a reduction in its variability and, therefore, sharecropping may be an efficient arrangement for both the supplier and the user of such an input. Kautilya recommended sharecropping, if a farmer supplied water from his private water-works to the neighbouring farmers. He (p 231) stated, ‘Owners may give water to others by dredging channels or building suitable structures, in return for a share of the produce grown in the fields, parks or gardens (3.9).’ Such an arrangement offered incentives for both of them,and additionally, being neighbours, the cost of ascertaining the level of output would have been minimal.
Supervision and Wage Payment System on Crown Land: Crown land was to be managed by the Chief Superintendent of Crown Lands. According to Kautilya (p 313), the Chief Superintendent ‘Shall be conversant with the science of cultivation, water management and the proper care of plants (2.24)’ and he (p 314), ‘Shall employ such experts as are necessary in order to cultivate profitably Crown lands and supervise the following operations: seed collection, land preparation, seed preparation and sowing, manuring and protection, harvesting and threshing (2.24).’ Kautilya (p 315) added, ‘On Crown lands, he shall employ slaves, labourers and persons working off their fines (2.24).’ These workers would be provided food according to their family sizes and a cash wage of one and a quarter panas per month.
It is obvious from the above statement that Kautilya recommended supervision where management had a better knowledge of the production techniques than those of the workers. That is, he recommended a wage system where close supervision was required on efficiency grounds and sharecropping where wage labour was not available.25
Sharecropping on Crown Land: Kautilya (p 315) suggested, ‘The Chief Superintendent of Crown Lands may lease out land that cannot be cultivated directly. Those lessees who provide only labour [the seeds and implements being provided by the Crown] shall get one fourth or one-fifth of the harvest. Those lessees who provide all the inputs shall get one-half of the harvest. Those who prepare new [Crown] land and bring it into cultivation for the first time shall pay an agreed amount. In times of distress, the payment may be foregone (2.24).’ Apparently, sharecropping was recommended when the state did not have the manpower to cultivate it.
SUMMARY
Kautilya was definitely aware of the principal-agent problem, which
arises whenever institutional structures are created. He explored many types of incentives to mitigate the harmful effects of the agency problem. He recommended moral motivation along with a judicious mix of efficiency wages, and investigation to elicit optimum effort, honesty and loyalty. Kautilya’s analysis provides several valuable insights, such as (i) if possible, an attempt should be made to match an incentive-type to an agent-type. (ii) Material incentives should be tailored to an employee’s hierarchical position and under certain special circumstances, imposition of some restrictions on him may be desirable. (iii) Most important of all, material incentives be designed in such a way that they are perceived as fair, so that moral motivation is not undermined. Kautilya’s insights are as relevant today as they were two thousand years ago.
12
Taxation: Principles and Policies
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
—Kautilya (p 239)
Kautilya proposed several principles of taxation, such as fairness, which included a safety net; stability of tax structure; collecting taxes only when they were due, that is, only after the harvest; maximization of the difference between revenue and expenditure, and fiscal federalism. He provided some unique insights into the possible origin of income tax and the institution of kingship. He formulated a whole set of economic policies to give a concrete shape to his vision of creating a prosperous economy. His approach was very methodical and complete. He suggested building up of taxable capacity through providing infrastructure, rather than heavy tax to raise revenue as such. Significantly, he recommended a linear income tax and tax compliance as an integral part of his tax system. Additionally, he showed awareness with several modern theoretical concepts, such as, the producer surplus, the Dupuit-Laffer Curve and the non-cooperative nature of the relationship between the taxpayer and the government.
He emphasized the financial health of the state and understood that a sound treasury was a prerequisite to accomplishing other goals. He (p 252) stated, ‘All state activities depend first on the Treasury. Therefore, a king shall devote his best attention to it. A king with a depleted Treasury eats into the very vitality of the citizens and the country.’ He (p 147) attached great significance to this aspect and envisaged that a king should start his day by receiving ‘reports on defense, revenue and expenditure.’ He added, ‘If receipts and expenditure are properly looked after, the king will not find himself in financial difficulties.’ Therefore, he emphasized that a king must carefully manage the financial affairs of the state.
Kautilya’s views on the origin of income taxation are provided in Section 12.1. His principles of taxation, such as fairness, stability, compliance and fiscal federalism are discussed in Section 12.2. He recommended the provision of a safety net for the poor, the old and the sick and thus supplemented the customary benefit principle by adding the ability to pay principle to it. He understood the limits to the government’s power to tax and this insight is discussed in Section 12.3. His ideas on a few related concepts, such as producer surplus, a functional classification of the government budget into the current account and capital account are discussed in Section 12.4.
12.1 ORIGIN OF THE INCOME TAX AND THE INSTITUTION OF KINGSHIP On the Origin of the Maxim ‘Taxation with Representation’: Kautilya mentioned the existence of a proportional income tax during his time.1 He also noted that the income tax and the institution of kingship originated together. According to Weller (1978, Vol 18, p 134) the war between the Pandavas and Kauravas took place around 3102 BCE and, even at that time, the institution of kingship was well established. Thus, in India, the income tax probably came into being more than five thousand years ago.
On the Origin of the Benefit Rule of Taxation: Kautilya (p 820) discussed the origin of income tax. He described it as: ‘When there was no order in society and only the law of the jungle prevailed, people [were unhappy and being desirous of order] made Manu, the son of Vivasvat, their king; and they assigned to the king one-sixth part of the grains grown by them, one-ten
th of other commodities and money. The king then used these to safeguard the welfare of his subjects. Those who do not pay fines and taxes take on themselves the sins of kings, while kings who do not look after the welfare of the people take on themselves the sins of their subjects (1.13).’
Attention may be drawn to some significant features of this approach. First, income tax was found more natural than a lumpsum tax. Secondly, the income tax rate itself was decided directly by the individuals. The rationale for income tax was based on the protection principle, that is, the benefit approach. It is also significant to point out that at that time too, compliance could not be taken for granted.
New Institutionalists’ Claim Validated: Hodgson (1998) argues, ‘Attempts to explain the origin and sustenance of institutions on the basis of the assumption of given individuals have internal flaws and inconsistencies. Accordingly, attemps to explain institutions in this way may have to be abandoned.’ He continues, ‘The central “new” institutionalist project of explaining institutions from individuals alone is thus misconceived.’ The [above] statement by Kautilya cited in the previous paragraph not only sheds some light on the origin of income tax but also supports the new institutionalist’s approach in explaining the origin of, at least, one institution, the kingship. It seems that at least Manu (more than 5000 years ago) was the first and perhaps the last king elected by the people.
12.2 PRINCIPLES OF TAXATION
Using an Imaginary Lump-sum Tax as a Standard: There are
two questions regarding any direct tax: is it feasible and what is the magnitude of deadweight loss created by it? A lump-sum tax does not produce any substitution effect, that is, it does not affect economic behavior and, therefore, does not create any deadweight loss. Although a poll tax was imposed in ancient Greece, Rome and some European colonies, women, paupers, handicapped and war veterans were exempted from it, implying that it could not be called a true lumpsum tax. Since income and service in the army were the underlying factors, which determined who would pay the tax, it implied that the tax could have affected economic behavior. Similarly, Seligman (1927-28, p 159-160) notes, ‘In some countries they have developed this poll tax according to classes, as the head of a workman is worth more than the head of a beggar and the head of a duke worth more than that of a workman, etc.’ The hard fact remains that no society has ever implemented a true lump-sum tax. Clearly, if deadweight loss were the only consideration, a lump-sum tax would have been preferred. Surprisingly, this historical fact is ignored and an income tax, which creates a deadweight loss because of the distortions caused by the substitution effect, is invariably compared to an imaginary lump-sum tax. Kautilya has been the only thinker, who made an attempt to explore the possibility that there might be some other types of costs associated with a lump-sum tax. According to him, political stability was a prerequisite for economic development and fairness was essential for political stability. He believed that a lump-sum tax might be considered unfair by the public and therefore, was likely to create resentment, political unrest and impose heavy cost on the economy. He, as discussed below, suggested measures such as an income tax and administration of justice to ensure fairness in all walks of life.
Kautilya- the True Founder of Economics Page 21