Behavioural economics these days has started to study everything from the level of motivations (of human behaviour), as opposed to classical economics, which used to study symptoms, the result of human behaviour. This new way has corrected many of the distortions in economics. Some of these were as flawed as Darwin's studies, which jumped to conclusions about the sexual behaviour of a species by looking at the breadth of a man's shoulders!
Tracing the roots of behaviour is good practice not just for individuals but also for institutions and societies. To understand money, you have to trace its definition right back to the Stone Age and its evolution thereafter. Similarly, taxation cannot be understood without a reference to the principles of banditry, which is where the role of the state started to be defined. The story of money and taxation will be long indeed, but we have to start somewhere.
Money happened just 10,000 years ago, and its creation sits at the watershed moment when humans went from barter to the beginnings of the division of labour. Only after the invention of money could you divide labour into complex, supporting roles that helped those who procured food, the hunters and the agriculturists. Its first role, therefore, was to help as a 'medium of exchange', which allowed the development of the primary, secondary and, later, the tertiary economy.
Secondly, only after the creation of money did the concept of wealth emerge. This gave money its role as a 'store of value', creating a relationship between wealth and income - what we know today as the interest rate. Eventually, this would create the largest commodity market in the world (aka the money market), linking all the other markets of the world.
A third dimension of money is to measure economic productivity, the relationship between kinds of labour, and between labour and the other factors of production (land, organisation and capital, i.e., wealth).
Taxation started in the earliest societies as the 'bandits' share', the hafta collected by the dominant bandits, sometimes as protection money for security from other bandits. As the role of state evolved to cover the regulation of commerce and hence the controller of money, the state became the major issuer of 'currency', a particular kind of money that was mainly used to lubricate the wheels of commerce. From here, currencies started to become a store of value, which is when the struggle appeared between state-taxation systems and currency as a repository of value.
The first milestone was when currencies which were themselves useful but perishable (bushels of grain, bearskins, livestock) moved to commonly accepted and non-perishable format, i.e., metals. After experimenting with many metals, the world settled down with gold/silver, growth rates of whose total mined stock closely tracked the global population growth rates or rather GDP growth rates. By the end of the nineteenth century, most major economies had settled on the 'gold standard', with which all paper currency came to be denominated in ounces of gold. Government treasuries across the world started to become the trustees of gold, issuing paper currency as IOUs against them.
From here, governments went back to their former role as bandits, issuing ever-higher nominal denominations against the same real gold, until, in 1971, the last major country (US) went off the gold standard and created a 'dollar standard', where other countries held their currency reserves in dollars. While the US became the bandit's bandit, it became ever easier for lesser countries to issue new currency, even as they held dollars. So while the dollar depreciated against gold (from $37/ ounce in 1971 to $1,300 now), the Indian rupee depreciated against the dollar from `7 to `67 now. India holds gold reserves of roughly 1 per cent of M3, the broader measure of money supply. This is an indicator of the extent of 'banditry', the transfer of value to the state.
Currency issuances today are a mirage. Currency is of value only because someone else will accept it; it has no intrinsic value any more. Shaking this faith is fraught with danger, and achieving a modicum of tax compliance at the cost of this faith is really playing with fire.
So the state has a role as the tax collector and as the repository of this faith in money. Should it really compromise one at the cost of the other? Which role is more important? Who decides and how just which is more important and when?
Right now, in this demonetisation debate, it is very important to sit in judgement of which role of the state is more important and whether it should ever give primacy to its role as 'chief bandit' over its role as a trustee of the most trustworthy job in the economy: being the custodian of the value of its currency. A very important part of the latter is the underlying faith that the citizenry has in the various roles of its currency. Given that the intrinsic value of the rupee is only 1 per cent of the nominal value, the rest of the value is derived from this faith.
If we all agree that the state stands to gain `5 lakh crore from the recent 9/11 exercise, it has directly impacted faith in about `120 lakh crore of issued money (M3). Would you call it a good idea?
To the writ petitions pending in courts, which would focus on the pain to the 'common man' and the subsequent loss of faith in the Indian currency, I have to remind them that this is to be viewed as the first of the many moves that will rebuild faith in the Indian currency. One, it will improve the public-debt ratio, reduce inflation and hence improve the ratio of intrinsic value to nominal value. Faith refers to credibility among honest holders of the currency; the faith of thieves and bandicoots is not the duty of the Indian state.
By asking a citizen to identify himself before the bank and hence leave an audit trail, the Indian state is not reneging on the implied promise embedded in its coinage, of repaying on presentation the IOU in the rupee, but is merely seeking to satisfy itself of the bona fides of the presenter. After all, you could be a terrorist, a foreign national or an insurgent holding counterfeit currency. If there is no check on you (and hence on counterfeits), faith in the Indian currency is anyway lost.
So, regardless of the fact that taxation traces its lineage back to the bandit's hafta, it remains the mainstay of the government's budget, and now produces useful public goods, even if the payers still feel cheated, as they did back then. The difference is only in relative satisfaction. The probability that a farmer would be killed as he transported his goods to the market was far higher than the probability that you will be killed on the road today. For the same level of taxation, you get far better (protection) services today and much else besides.
The tax dodger does not cheat the state as much as he cheats his fellow citizens. The resulting deficit is funded by new money, which dilutes old money uniformly and equally, diluting another objective of taxation: to punish/penalise bad behaviour.
In this case, tax avoidance not only goes unpunished but gets rewarded, and the resulting inflation (that comes from high tax avoidance) punishes the honest populace. And since the punishment from inflation hits selectively at those who have weak bargaining power, it hits at the bottom of the pyramid. That is a double whammy to social justice.
And tax avoidance also distorts the incentives to good behaviour, thus reinforcing bad behaviour in an ever-increasing spiral, till all good behaviour is driven out by bad behaviour. This is also the essence of Gresham's Law.