Kautilya- the True Founder of Economics

by Balbir Singh Sihag

  Apparently, humanity has been concerned with fairness since antiquity. For example, Kautilya recommended an income tax when a lump-sum tax might have been feasible. He (p 820) linked the origin of income tax to the benefit principle. Kautilya accepted the customary income tax on agricultural income. The non-agricultural income, other than those of prostitutes, was taxed only during emergencies. He believed that merchants dealing with gold and silver must be making more money than those dealing with wood and accordingly recommended a graduated tax. He (p 271) suggested taxing merchants and professionals as follows (in terms of pana that was the unit of account and medium of exchange at that time):

  Gold, silver and gems 50 panas Copper, brass, perfumes etc. 40 panas Grain, liquids etc. 30 panas Workers in glass and other

  highly skilled craftsmen 20 panas Other craftsmen 10 panas Wood, bamboo, stoneware and earthenware 5 panas

  Similarly, he suggested a graduated tax (during an emergency in addition to the regular income tax of 1/6th) on land holdings according to the yield from them. He (Kangle, part II, p 296) suggested to the king, ‘He should demand a third or a fourth part of the grains from a region, whether big or small in size, that is not dependent on rains and yields abundant crops; from a middling or inferior one, according to yield (5.2).’

  Kautilya accepted an income tax partly because of the fact that he was unaware of the concept of deadweight loss but primarily, perhaps due to concern regarding the possible disruptive effects of a lump-sum tax. Although he did not say it explicitly, but his awareness may fall into the category of what Waterman calls ‘read into’—that a lumpsum tax was unfair and could create resentment and lead to political instability and disruptions. That is, given his views on the absolute need to be fair in all aspects of human activity, it seems quite plausible that he understood the cost of disruptions of a lump-sum tax. That means that the current approach ignores the possible disruptive effects of a lump-sum tax. Kautilya’s ideas essentially amount to comparing the impact of a lump-sum tax to that of an income tax on earnings and risk. He considered a situation where, suppose more revenue could be collected by a lump-sum tax (it does not have a deadweight loss), which permited a higher level of public infrastructure and helped in raising the earnings of an individual more than under an income tax. However, according to Kautilya, the probability of retaining those

  Figure 12.1:π0 E0 the initial possibility frontier. Lump-sum tax shifts it to π' E' and an income tax shifts it to π" E".

  higher earnings rose more under an income tax than under a lumpsum tax. Figure 12.1 may be used to capture his ideas. E0 and π0 represent an individual’s earnings and the probability of retaining his earnings, respectively. That is, an individual allocates his time between working to earn money and taking protective measures to retain it. Suppose taxes are imposed to provide protection of private property rights and establishing law and order. A lump-sum tax is likely to shift the possibility frontier to π' E' and an income tax to π" E", and it would be difficult to say a priori whether a society prefers any point to the left of R or to the right of R, that is, whether it prefers an income tax or a lump-sum tax. However, as noted above, the choice has been definitely in favour of an income tax.

  The current approach compares point E" to point E' since it assumes that the law and order situation is unaffected by the type of tax. Unsurprisingly, a lump-sum tax is declared better than an income tax and the equity-efficiency trade-off is confined essentially to the segment E"E', whose length depended on the specifications of the income tax. However, Kautilya wanted to exclude any possibility of disruptive effects caused by a lump-sum tax, since maintenance of law and order was considered critical for survival and economic progress. It is obvious that Kautilya’s ideas complement the current approach, which focuses only on the deadweight loss of an income tax and ignores the possibility of negative consequences of a lump-sum tax.

  Kautilya had two additional reasons for adopting an income tax. By definition a lump-sum tax has to be uniform. He was concerned about the well-being of the poor, who couldn’t pay any tax and needed help. He (p 182) suggested, ‘King shall maintain, at state expense, children, the old, the destitute, those suffering from adversity, childless women and the children of the destitute women (2.1).’

  His Arthashastra may be described as a treatise on the imperative of economic growth. As mentioned above, tax revenue was necessary in providing infrastructure, army and armament. As also mentioned earlier, 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 linked tax revenue to economic prosperity. He (p 116) suggested, ‘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).’ A lump-sum tax could not raise the desired level of revenue since its magnitude would be constrained by the paying capacity of the poorest in the society. There is some evidence on this. For example, Seligman (1927-28, p 159-160) mentions that some Southern states in USA imposed a poll tax with the clear intent to deny the poor Black people from exercising their right to vote since they, it was thought, would not be able to pay the tax.

  It may be noted that there would be no shift in the possibility frontier if the revenue is siphoned-off by corrupt public men (that would include both politicians and bureaucrats in present times). That is why Kautilya was much concerned about corruption. For example, as was mentioned earlier too (see Chapter 9, Section 9.3), he (p 281) stated, ‘Just as it is impossible to know when a fish moving in water is drinking it, so it is impossible to find out when government servants in charge of undertakings misappropriate money (2.9).’ He devised various ways to reduce it.

  Combined the Ability to Pay and the Benefit Principle: According to him, a tax rate lower than 1/6th would reduce tax revenue and consequently reduce the provision of infrastructure and public goods—national defence, and law and order. He (p 125) added, ‘It is the army which is dependent on finance. If not paid, [the soldiers] either go over to the enemy or even kill the king. Finance is necessary to undertake any state endeavor and is the chief means for both dharma [righteous duty] and kama [enjoyment] (8.1).’ Similarly, he argued that a tax rate higher than 1/6th would anger the taxpayers and might result in a reduction in tax revenue (see more below in Section 12.3). One may wonder why he accepted the existing income tax when the imposition of a lump-sum tax seemed feasible. There may be several reasons for that: (i) the most important seems to be that income tax was sanctioned by a majority of taxpayers. (ii) He realized that fairness was not merely an end in itself but also a means to ensuring political stability. A lump-sum tax could generate political instability by creating a perception of inequity and thus, might lower the overall economic efficiency. Models, which compare an income tax to a lump sum tax by assuming a representative taxpayer, assume away the possible disruptions caused by political instability. (iii) A per head tax might have encouraged migration of people to other regions, thus compromising national security.

  Safety Net: There was a very clear demarcation of responsibilities between the individual and the state. According to Kautilya (p 182), ‘Every man has an obligation to maintain his wife, children, parents, minor brothers and dependent (unmarried or widowed) sisters. No man shall renounce the life of a householder in order to become an ascetic without providing for the maintenance of his wife and children (2.1).’ The head of the household was primarily responsible for the family and there was a punishment of 12 panas (p 194) for the failure (2.1). However, he (p 182) suggested, ‘King shall maintain, at state expense, children, the old, the destitute, those suffering from adversity, childless women and the children of the destitute women (2.1).’ He (p 293) added, ‘If a government servant dies while on duty, his sons and
wives shall be entitled to his salary and food allowance. Minor children and old or sick relatives shall be suitably assisted. On occasions such as funerals, births or illnesses, the families of the deceased government servants shall be given presents of money and shown honor as a mark of gratitude to one who died in the king’s service (5.3).’

  The above statements indicate a comprehensive package of benefits: disability payments to those suffering from adversity, social security to the old, supplemental security income to the children and welfare payments to the poor.

  Anticipation of a Linear Income Tax System: The true appreciation of Kautilya’s insight on income tax may be gleaned by comparing it to the recent developments in the theory of income tax.2 It is apparent from the above discussion that he implicitly recommended a linear income tax with the marginal tax rate, being 1/6th (if T=tax revenue, Y=income, T= —a +b Y, T= —a if Y=0 and T=b Y for Y>0). Moreover, no exemptions, other than a very few for promoting new investment, were allowed, and, therefore, it comes very close to the comprehensive definition of Haig-Simons (see Atkinson and Stiglitz, 1980, p 260 for details) for the income tax. Surprisingly, the magnitude of the flat income tax rate mentioned in political debates in the USA is not much different from 1/6th, the rate recommended in the Arthashastra.3

  It appears that Kautilya implicitly combined both, the benefit principle and the ability to pay principle. According to both, the benefit principle and the ability to pay principle, rich people should pay more.4 However, the benefit principle does not allow any subsidy to the poor. But he suggested the payment of a subsidy to the poor, implying the use of the ability to pay principle.

  Collecting Taxes only when they are due: According to him, it made no sense in collecting taxes before the crops were harvested. Since (i) taxes were due only after the harvest, (ii) it was useless to collect raw grains and (iii) also annoyed the farmers. He (p 253) observed, ‘Just as one plucks fruits from a garden as they ripen, so shall a king have the revenue collected as it becomes due. Just as one does not collect unripe fruits, he shall avoid taking wealth that is not due because that will make the people angry and spoil the very sources of revenue (5.2).’

  Maximization of the Net Tax Revenue: Kautilya (p 218-220) envisaged a Chancellor, who was to be responsible for: ‘(i) the collection of revenue from the fortified towns, the country-side, the mines, the irrigation works, forests and trade routes, and (ii) the preparation of the budget and maintenance of detailed accounts of revenue and expenditure as prescribed (2.6).’ As discussed in Chapter 5, Kautilya introduced accounting methods and every official had to follow the format. Also, the officer had to constantly manage the revenue as well as expenditure such that the net did not fall. He (p 220) added, ‘A wise Chancellor is one who collects revenue so as to increase income and reduce expenditure. He shall take remedial measures if income diminishes and expenditure increases (2.6).’ He would reward those officers who were honest and collected tax only what was due. Kautilya (p 281) recommended, ‘Those officials who do not eat up the king’s wealth but increase it in just ways and are loyally devoted to him shall be made permanent in service.’

  Stability of the Tax Structure: As mentioned above, during normal times, he accepted the customary income tax rate of 1/6th on agricultural production on private farms and on income of private prostitutes. There was no income tax on the salaries of state employees. Merchants paid some sort of professional taxes only during emergencies. Undoubtedly, the tax rates were different for normal and emergency times but were known in advance. Thus, he preferred a stable tax structure and similarly, the existence of a few exemptions on investment created only a little uncertainty regarding the tax base.5

  Fiscal Federalism: Kautilya specified the sources of revenue for the central government and for the villages separately.6 Villages collected their revenue mainly from charges for grazing and fines levied on the villagers for not participating in community works. He (p 366) mentioned separately the charges for grazing only, grazing and resting and grazing and staying overnight.

  Village Governance: According to him, the Village Headman and the Village Elders were responsible for managing the village. He (p 182) recommended, The village elders shall act as trustees of temple property and the inheritance of minors (till they come of age) (2.1).’ He (p 432) suggested, ‘Boundary disputes between two villages shall be decided by a group from the neighbouring five or ten villages, using natural or man-made boundary marks (3.9).’ He (p 427) added, ‘When a debtor is unable to redeem a pledge because of the absence of the creditor, he may deposit the amount due with village elders and take away his pledge (3.12).’

  He (p 365) listed the responsibilities of the Village Headman as follows: ‘(i) The Village Headman shall have a fence with pillars erected all the way around the village at a distance of 600 feet from it. (ii) He shall ensure that cattle do not graze or stray into cultivated private fields or gardens or eat the grains in storage sheds and thrashing fields and shall be responsible for protecting them from injuries or harsh treatment. (iii) He shall collect the revenue for the village from the charges levied on grazing in common land, from the prescribed fines and the fines levied by the state. (iv) He shall not eject any settler from a village except for reasons of theft or adultery (3.10).’ It may be noted that it appears that the enclosure movement in India took place almost two thousand years earlier than in England (see Ashton,1972, p 38-48 for details). But more important: ‘Local matters were in local hands.’ Apparently, fiscal federalism was possible even under monarchy.

  Kautilya tried to develop ‘civic virtues’ of cooperation among the villagers.7 He (p 365) stated, ‘All the people in a village shall contribute their share of the community work and costs of festivals and entertainments (3.10).’ He added, The people of a village shall obey the orders of anyone who proposes any activity beneficial to all. They shall not conspire against such a person to attack or harm him. When the Headman has to travel on village business, he shall be accompanied by some of the residents of the village, who shall take the duty in turns (3.10).’

  Compliance: First of all, it appears that Kautilya believed that tax compliance depended on the tax system. He recommended an income tax on agricultural income and a form of occupational tax on nonagricultural income to plug loopholes for income-shifting. He (p 271) stated, ‘The tax shall be recovered, in cash, from those skilled in their work. Their offences shall not be forgiven, for they are apt to [evade the tax and] pretend that the sales made by them were on behalf of someone else (5.2).’ Apparently, he was aware of the difficulty of collection of an income tax on the non-agricultural income, due to the scope for tax evasion. On the other hand, a tax collector could go to the agricultural fields at the time of harvesting and have a pretty accurate estimate of the output and the resultant tax liability. This is not a far-fetched possibility. For example, Bennett (1999, p 25) states, ‘Others, however, have pointed out that there exist in modern India professional appraisers, called kaniya, who estimate the crop yield for land-owners with uncanny accuracy. Because their reliability has been established from year to year, their results are rarely questioned.’

  Slemrod (1990) notes, ‘If optimal tax theory is to be a reliable guide to action, it must consider the issues that arise in operating the tax system.’ Enforcement was an integral part of Kautilya’s tax system. There was a Record Keeper for every five to ten villages, who kept detailed records on almost everything in the villages. The Record Keepers were responsible for collecting the taxes and there were magistrates to ‘inspect their work and to ensure proper collection of taxes’ (2.35). Additionally, he (p 510) recommended, ‘Spies in the guise of ascetics shall be [directly] responsible to the Chancellor for reporting on the honesty or dishonesty of farmers, cowherds, merchants and Heads of Departments (2.35).’ Thus, Kautilya’s discussion on taxation may fall in spirit under what Slemrod calls ‘the realm of optimal tax systems rather than optimal taxation.’

  Tax evasion in the Arthashas
tra was treated as a criminal offence and the penalty was related to the magnitude of tax evasion rather than the magnitude of income concealed. Interestingly, this is more like the American penal tax code than the British penal tax code (which is the currently prevailing one in India). Relating the penalty to the magnitude of tax evasion is desirable, as Yitzhaski (1974), shows, only then does its effect become predictable.