extracted text

THE HAGUE, 2k August 1954
Sijzenlaan M

PROP. DP. J. TINBERGEN

Mr N.V.A. Narasimiiam,
Andlira university,
8/1731, Official Colony,
Visakhapatnam ~ 2
Andhra State,
India
Dear Dr Narasiniliani,

,^
^fv
'''^ '

I got your letter of August 6
as well as the one of May 21 and your article,
I tried to ask the Faculty of the 1? o-^^ ter dam
School of .Economics ahout your eliglDility
-j^.^.^ there was such a crowded program of
discussions that I did not yet get the approval.
I hope to he ahle to do so in Septtrriber,
You might meams,'hile write a letter to the
Netherlands Ministry of Sducation (Kieu'v^/e
Uitleg 1, the Hague) since thej- have to
decide in this matter and will ask the
. School's advice. My stay in India has heen
postponed and v/e might therefore try to fix
this matter hy correspondence,
I want to th-ank you for yoia?
article and for the interest you took in
ray method, I am afraid there are some
misunderstandings included, "out it would
certainly he interesting to discuss theia
with you in order to eliminate than, I may
mention the most important ones "briefly.
At £ajge_Jj£2_yo^ assume the portion of national
income going to workers to oe 0,68 (indirect taxes expressed in total tax revenu^),
I am afraid I do not understand this at all
and anyhow my guess T/ould he that laoour
income in India might he lower hecause of
the very large nuinher of small independent
employers.
On page li-t-S you mention figiires for the
marginal wage quota which I am afi'aid are
very high indeed. I would assume them to "be
not more than -^ and possihly quite a hit
lov.er,
0^ page 1U9 yo'or interpretation of the values
fo\ind for government e.xpenditure should he
0,4 % of national income which is rather much
more than Ci+z^ae^gD/ernment estpeiiditure,
^^ page 151 the last sentence of the first
paragraph: " tChe former explanation holds in
the case of positive solutions'.*., is not correct.
These few points may illustrate
that some important corrections would have
to he made. Personally I am certainly willing
to work vlt.h youj I shall let you know at my
earliest possihility what the Faculty's
opinion is.
Yours very sincerely,
ï''

y
/

•

•
/•

0

\

/^^.i^cxT^-"^

*

f

f

^^^^%Mjk

PRICaS-WAGE-TAX-SUBSIDY POLTCIES

Rep r i sot f rem
IHDI/iN JOURKAL OF ECONOMICS

UJ-t/ïC C->vv»X. -yvJUrJ^

PRICE-WAGE-TAX-SUBSIDY POLICIES AS INSIRUMENTS IN
INCREASING OUTPUT*
BY
N. V.

A.

NARASIMHAM,

Andhra Univermiy, WaUair
SUMMARY

Following a method analogous to that adopted by J. Tinbergen
for the Dutch economy, study has been made in the first part of this
paper of likely structures of the Indian economy in respect of year-to-year
changes in real national income within the last few years. 1 In the stcond
part the bearing of these macro-dynamic economic structures on the role
of price-wage-tax-tariff-subsidy policies in increasing immediately national
output has been explained.
The main results of the present study are :
(i) Inflationary forces are embedded in the very structure of
Indian economy. Under present conditions, immediate
expansion of output is possible mainly by employing
increasing amounts of labour on the more or less fixed
stock of capital, and this naturally causes productivity to
fall, and costs and prices to rise. The great upward shift
in post-war cost-price structure has to be attributed mostly
to this structural deficiency.
(2) An empirical examination of the view that foreign investment increases domestic output shows that it holds good
for India, but the shift in domestic output brought about
by such investment appears to be quite small.
(3) Under the prevailing conditions in India, investment for
immediate expansion of output necessitates a reduction in
real expenditure of the community in the present. If
voluntary abstinence from consumption through increased
community savings is not possible, which is particularly
true in a low-income country like India, then the main
methods. I left for the choice of the government would be :
increase in indirect taxes and reduction in subsidies to
consumption. The last two methods wouldmean, in

*

This paper was formerly submitted 0 'he All India Economic Conference

held

at Patna ia December; i95i.
I. The author is not aware of any other attempt at eitimation of the economic structure of India. In considering the various inverted problem», vh isolated investment
policy, isolated price policy, etc., the objective is Wi»/«0' toillutrate the i-ractical utility
of structural estimation in policy decisions.

144

fact, -a reduction in community's consumption by means of
raising prices to the required degree.
(4) A comparison of the effectiveness of an isolated wage-policy
with that of an isolated price-policy shows that the former
is less efficient than the latter in increasing output. A
control over wage-rate does not give control over labourcost (per unit of output) which influences the size of output directly ; because labour-cost is determined not only
by wage-rate but also by productivity-of-labour which is
likely to fall with an increase in employment in India.
(3) Direct price-control by government, or a liberalisation of
trade {/. r., an increase in competition) by means of a reduction in the protective tariffs that are enjoyed so far by
the high-cost producing industries is sure to bring about
considerable expansion of output in the immediate future,
J.

Introduction

The people who plan are generally faced with alternative policies
leading to the same goal. There is not much point in trying to find
out the effects of any policy after its implementation. The purpose of
econometric research has been to find out in quantitative terms the possible effects of any policy before i t is implemented.
•'-.•";'..'Decision models' have been considered by I^arschak, Frisch,
Tinbergen and others. Such constructions form a powerful tool of
economic analysis as they combine economic theory and statistical inference, and assist the economist in comparing the effects of different kinds
of policy and in deciding finally on the one which leads to the goal set
before him.
The economist is often asked to advise on policies of a government or a firm. This requires him to estimate the effects of a given
(intended or expected) change in the 'economic structure.' He cannot
produce this change, as in a laboratory experiment, and study its
effects beforehand. In other words, he has to estimate the effects
of changes which he has not observed, or can never possibly hope to
observe. This makes his method peculiar. He has to estimate, first
of all, the past - ( o r observational) structure, (.'., the economic
structure before the change. After estimation of the past structure,
he has to estimate the effects of various types of variations in it producing dift'erent new structures (or future structures) by comparing
which he can choose just those variations which would produce the most
desirable economic structure. The operations of estimation of past
structure, of estimation and comparison of effects of varying it characterise^ the decision models.

"•'^'^

PRTCE-WAG-E-TAX-SUBSIDY POLICIES

N. V. A. NARASIMHAM

For estimating the past structure, a theoretical model has to be
built at first. As the scope of this paper does not permit such an
attempt, wide use is made of Tinbergen's decision model in this paper.
This model is chosen not only for its simplicity and efficiency in explaining the changes of the most strategic economic variables, vi^. level of
national o u t p u t , labour cost per unit of output, price-level, balance of
payments, but also because it is well adapted to incorporation of the
magnitudes of constants known through other sources of information
than multiple-correlation studies which are difficult to be attempted for
India in the absence of adequate data.
2.

Tinbergen's De'isioti Model
Tinbergen's model is a system of linear

of a dynamic and stochastic character.

simultaneous equations

As the definitional equations do

not involve any structural constants, structural equations only are considered here.
(i)

The latter are called

The demand equation for National product by the home

market :
(2)

The demand equation for that product by the world market :

(3)

T h e supply, or price-fixation equation for that product :

where y, p, D are deviations of real national income, general price-level,
and deficit in balance of payments ; /', labour cost per unit of output ;
t an autonomous increase in national expenditure caused by many
factors like 'taxation, subsidisation, or governmental investment ; and
' j j similar autonomous changes in the margin of profits caused by
factors like governmental price-policy oY' liberalisation of trade. The
last three variables are called the political parameters, as they are determined individually or in combination, by the Trade Unions, Government, and private entrepreneurs.
3,

Proctdure of Bstimation
The procedure in Tinbergen's estimation of the seven

constants, 5 . , I,,

?^='>, TT,, TT^ and [A is rather peculiar.

structural
It con-

sists of two stages : In the first stage, the above constants are shown
to depend on (or derived from) certain fundatnental constants the knowledge of which he gets on the basis of his hypothesis about structural
equations, namely economic theory.

The theory that he employed is

PRICE-WAGE-TAX-SUBSIDV POLICIES

146

N. V. A.

(i.e., with the tiiaximum probability^ to represent the year-to-year
changes in post-war economyJ& ^
At the next stage, a 'close scrutiny is made of the residuals
computed for the different alternative empirical structures tried.

a logical combination of the two lines of thought in the present-day
economic literature, namely the income approach for which KeynesMachlup-Meade models are typical, and the price-approach of Bickerdike, Joan Robinson, Polak, Metzler, etc. The equations are given as
follows :
^ i = -

(i-A)

^2=1-

x+ ^

147

NARASIMHAM

.••;:

(."4-A— H^"")

^= m <""+7 i'^'- I)
where

•''

_
^ | B

x= Total real expenditure,
(i - ,3- ) •-Marginal propensity to spend of non-workers.
\x = Marginal import quota.
m = Value of imports.
A = The wage-quota in the national product.
£""= Elasticity of imports with respect to the domestic price
level (foreign prices being taken constant)
•',•- Volume of exports.
" •- Absolute value of Elasticity of exports with respect to the
home price-level.
A-i = Marginal wage-quota (which may be interpreted not so
much as a variation in the marginal wage-quota proper,
but more as the tendency for certain trade margins to
move in sympathy with labour costs).
Tra = The flexibility of prices ( or the inverted supply elasticity).'^
Generally, the coefficients, HjE^.e^TTuTT.^, =^ are taken from
multiple-correlation studies for the inter-war period i9z5 to i938.
But as a result of World War II, a number of changes have taken plaee
in the structure of every economy necessitating alterations in these
coefficients. So Tinbergen had to use a number of alternative trial
values'* of the coefficients and construct alternative economic structures with a view to choose one with the least margin of uncertainty

2. X, m, e, D indicate the initial valuei of x, m, e, and D.
3. The simultaneous equation method of statistical estimation, as Leontief
points out, is fortuoately well adapted fur incorporation of such magnitudes of stiuotural
constants known through other sources of information. It always cm be used, according
to him, as a last resoit for estimating empirical coefficients which cannot be evaluated on
the basis of some less indirect and more reliable inductive procedure.

Generally, the ohserved values of economic variables include
random disturbances, and the relations (equations) connecting them
have therefore to include random or "error" elements. Economic
theorists are a Iready familiar with the necessity of introducing random
or "error" elements into the description of economic relationships.
The recent stochastic approaches require a specification, as an integral
part of the scheme, of the probability distribution of such random
"errors". The estimates of such "errors" computed from observations
are called "residuals".
The residuals of the model under study are given by
U, =
r ^ , y + D -f E s p - ^gr
U, = - ,„, y -f. D - <5 p
U3 = - TVi y +
p - TT^ r
where Ujj'U^ and Ug are assumed to be independent, and normally distributed with the same>ariance.*
4.

y

W ^

r

Application to Indian Economy\: Likdj Structures

For the situation in 1948-49, 5, m, e, and D are fairly exactly
known from the national income estimates ; they are respectively equal
to 1.02 (national expenditure expressed in national income), 0.08 (imports
expressed in national income), 0.06 (exports expressed in national
income), and 0.02 (deficit in balance of payments expressed in national
income). As A, (portion of national income going to workers) is not
directly known, it is assumed to be fairly related to 0.68 (indirect
taxes expressed in total tax revenue). The inverted supply elasticity n^
is taken as o'6i5 (the ratio between percentage changes in general
price-level and total production).
In view of the uncertainty of some coefficients, a- ^ ^^ g^, ee, ^,
a number of structures have been considered by giving different possible
values to them within their limits J^- variation. These values are the
general conjectures of economists. As regards the itiarginal propensity
to save of workers, it is considered to be fairly exact to assume that

4. 3/2 (Sample variance) is then an unbiased estimate of the variaLce of population
af errors. .

5

148

N. V. A. NARASIMHAiM

PRIOE.WAGE-TAX-SUBSIDY POLTOIES

it is zero. But as regards the marginal propensity to save of nonworkers, °~, we know it should be positive, but we are not certain about
its exact value. So we have to give different conjectural values which
are positive and less than unity. Similarly we do for ji, the marginal
propensity to import. As regards the import and export elasticies, e"",
e<= , a greater range of (positive) values can be tried, because they are
elasticities with respect to the domestic price-level. Some of the likely
sets of values of these coefHcients are given in Table I :

payments D. Here the values of /', l^, 77^ (polieJB*- parameters) are
known while those \o( y, D, p are unknowns. But what more is
expected from a decision model is this : It has to assist the policy-maker
in knowing what amount of variation is to be made in a particular
parameter ^^ {or I' or TT J in order to bring about a given change, say in
J , which is the directive (objective) of his policy. Here, the problem
is inverted : r, now being given and ^^ unknown. The other parameters /' and TTo ^^^> however, given, and so, D and p are the other
unknowns (same as before) in the equations. Such inversion is
characteristic of a decision model. The following cases are examples
of such (partially) inverted problems.

Table I
Structure No.

1

2

3

4

S

6

7

o- ;• Marginal prop, to save

o.z

o.i

o.i

0.2

0,2

0.2

0.2

£""

Price elasticity of imports

o.3

o,3

o.3

o.3

i.o

0.8

o.3

£.

Price elasticity of exports

1.5

1.2

1.5

2.0

2.0

2.0

o.5

[A

Marginal prop, to import

0.2

0.1

o3

0.2

0,2

0.2

01

o.S

0.6

0.4

0,8

i.o

0.8

o.4

6.

- TTi Marginal wage quota

Table 11
1 2

3

4

5

6

5i = o*32^

0064 o'o32 o-o32 o'o64 O'o64 o-oó4 o-o64

^2=-o-o2+=^(l^^°"^f[)

o-i44 0-055 o-o69 o'i44 o-ii6o-i24 o-i3o

^3>=o'68a-

O i3a o'o68 o-o68 o-i36 O T 3 6 O ' I 3 6 O " I 3 6

(5 = o"o8e'"— o'o6(£«-i)

o'o54 o"o36 -o'ooó o"o84 o"i4o o'i24 o'oo6

Isolated Investmsnt Policy

The problem here is to find out the actual increase in governmental expenditure 5Q if it alone were to be used as an instrument for
raising the level of production by (say) one per cent. That is, for what
value of ^o this condition y = o - o i i s fulfilled considering/'=7ro=o.
This may be solved by rewriting the equations (•), (2) and (3) putting
y = o-oi a n d / ' = - j r o = °
- ^ , - f D + 5 3 P = ^ , (v=o-oi)
D-(5 p=/«!/
p=7r_(/
and solving for ^^ leading to

With the help of the values listed above, the dependent coefficients
are found and tabulated below :

Structure No.

1

?0={/' + 5l+'n"2 (-5+^2) } (V=0-0I)
the numerical values of which are :
Structure No.
5Q=

5.

Directives and Instruments of Po/cy

The practical utility of knowing the structure of a country's
economy at any time is that we can know beforehand from the equations of the structure what would be the consequences of a given
change in wage-rate I', or in government price policy ir^, or in governmental expenditure ^^, on production r, prices 7>, deficit in balance of

1

2

3

4

5

6

7

O'OO4 O'OO2 O'OOJ O*OO4 O'OO4 O'OO4 O'OO2

(necessary for y =0.01)
It is interesting to note that the necessary increase in governmental expenditure by way of direct investment or its subsidies to
production, lies within the .range of real possibilities ; only o.4
per cent rise in governmental expenditure being required for raising
national output by i per cent.

Structure No. i is considered to be a more likely representation
of the Indian economy within the last few years.

n

149

V

7.

Isolated Price Policy

As against isolated investment policy, we may consider an isolated price policy, /. e., a policy of deliberate lowering of price margins,
say by price control or by a liberalisation of international trade or by
breaking up monopolies tending to increase competition. Ihe problem
is similar to the above one ; to find out the actual change in TTQ i° order

PRICE-WAGE-TAX-SUBSIDY

N. V. A. NARASIMHAM

150

that it alone can raise the level of production by i per cent.

The

method of answering is similar to the one used in the previous case. We,
therefore, give only the analytical expression for 77^ and the numerical
results :

Structure No.
TT

=

1

2

3

4

S

6

7

"

(necessary
for y = o . o i )
The meaning of these apparently small negative figures is very
significant. They show that an increase in competition among the
producers alone is able to increase output, by i per cent. This means
that the high profit margins enjoyed by domestic producers must be
reduced either by direct government control over profit-margins, or
(j by allowing the inefficient entrepreneurs, in industries like sugar,
1 to face foreign competition- A thorough revision of existing protective
duties seems to have a greater power of expanding national output.
This is obvious from the two sets of numerical results above. The
numerator of the analytical expression for TT^ is, in fact, the same as
that of ^o in absolute value. TT^ is greater than SQ by ((5+^2) times.
The reduction in profits-margin required for expansion of output
in this manner will be the smaller, the greater the value of ö. The
solutions for TTQ require 2 per cent reduction in profit-margin, which
is certainly within the range of real possibilities.
8.

Isolated

Wagc-?oticy

It is proposed in certain quarters that a fixation of wage-level,
or a reduction in the existing wage-rate, if possible, would expand
output. So let us know from our equations what should be the wage,
rate if production is to rise b y o . o i . As the method of answering is
similar to those above, it is enough if the analytical expression for
I' and the numerical results are given, (In order to be more precise
and scientific, we consider index of labour cost per unit of o u t p u t , / ' ,
rather than wage-rate per labourer, /.) =
o.oi^H + ^ i + TT, ( 3 + ^ , ) }
Structure No.
I'

1

2

?,

.4

5

6

7

- o . i 7 o.i4 0.11 -o.o9 -o.o4 -o.o7 o.o3

151

These results are outside the range of what could be considered
as small changes, and therefore outside the range of real possibility.
But they do not surpass anyhow the possible boundary condition that l'
shall not be less than — i . They are certainly meaningful. The high
positive and negative values of i ' c a n be better explained i f / ' i s split
up into its components, the wage-rate / and the index of productivity
h in the following way :
/'=(/-h)

= -0.02 - o 02 -o.o7 --0.02 -0.02 - o 02 -0.02

o

POLICIES

An increase in labour cost per unit
may therefore be due to
either an increase in wage-rate /, or a decrease in productivity h, or
both ; and similarly a decrease in I' may be due to a fall in wage rate or
a rise in productivity, or both. The former explanation holds in the
case of positive solutions for V ; and the latter for the negative
solutions.
Now, suppose the wage-rate is stabilised by the governatient
with the cooperation, of course, of labour unions. Then, the negative
solutions of /' require a rise in productivity in order that the
level of production might rise by i per cent. This is evidently
impossible in a period so short as one year. Let us then try the
positive solutions for I : The meaning of these solutions is that,
wage-rate being stabilised, productivity would fall and labour cost
per unit would rise with every increase in employment and output.
The significance of this result is that, under' ^existing conditions,
expansion of current output is possible mainly by employing increasing
amounts of labour on the more or less fixed capital equipment, and
this naturally causes productivity of labour- to fall and costs and prices
to rise. The great upward shift in post-war cost-price structure
might probably have to be attributed to this structural deficiency of
Indian economy. In the presence of such a fundamental drawback, the
wage-rate becomes an "inefficient regulator" in economic policy. ,
9.

Combined Foreign Investment, Price and Tax Policy

So far, the role of D in expanding national production has not
been considered, A surplus •( —D) in the balance of payments on
current account is generally considered by economic theorists as investment abroad, which tends to increase employment and output at home.
If foreign investment (—D) and our third parameter, ^Q, are to be
used for expansion of current output at home, then, the latter ^^ has to
be understood as a decrease in public expenditure, which may be in the
shape of a reduction in government subsidies to public consumption.

PR1CE-WAGE-TAX-SUBÖIDY POLICIES
152

l53

N. V. A. NARASIMHAM

Here all the three political parameters l^, l\ and TTQ are the
unknown s,'but we have only two equations (i) and (3) involving them.
If we know that I' is known once p i s given (/. c , if price is assumed
to be 1-5 times labour cost) then there will be two unknowns and two
equations involving them. If /'. ^o» ^^^ TTo a^e now expressed in
terms of D which now acts as a mathematical parameter, we get from
equations (i), (2) and (3), putting y = o . o i and p = i.5 /' :
I' ^ - ( o - o i n - D )
1-5Ö
TTa» - o - o i TT.^ + (TTi- I'S) I'
TTo-o-oi ^, - (1-5 ^ , - ^ 3 ) Z' + D
By expressing I' and p - i . 5 in D (with the aid of the above
equations) in the equation for deviation in real expenditure (Ref.
Tinbergen) we get :
x~o-oi + (oo2 - u + l* £"") ^-°i-**-^^—^' + D
d
If due to an increase, 0 0 1 , in real income, y, it is assumed that
expenditure is assumed to be more or less constant, then x (deviation
in expenditure) may be equated to o, and the value of D and hence of
the political parameters may be found. The results are ;
Structure No.
t
2
3
4
5
6
7
(—D) foreign
investment.

2.
3.

4.

the resulting increase in labour-cost per 'unit seems to take
place simultaneously with investment ;
the reduction in profit-margin necessary for increasing competition.is within possibility ; as the maximum reduction is
of the order of 20 per cent ;
the necessary reduction in national consumption is also
within the range of what may be considered as small
changes ; the maximum for such reduction being f 4
per cent.

As regards (2) and (3), 'explanations arc already given in
section 9 and 8 respectively. The significant point of this section is
that, under present conditions in India, any investment for immediate
expansion of output necessitates a reduction in real expenditure of the
community in the present. This may probably have to be attributed
to the relative constancy of the national output (or national cake) per
head. If voluntary abstinence from consumption through increased
community savings is not possible, which is particularly true in a
low-income country like India, then the main methods left for the
choice of the government would be : increase in indirect taxes and
reduction in subsidies to consumption. The last two methods would
mean, in fact, a reduction in community's real consumption by means
of raising prices to the required degree.
REFERENCES

-o'oo2 -o"oo9 +o'oo3 -o'oo3 -o'oiz -o'ooS -o*oo3
1. J. Tinbergen :

r, increase in
employment.

o-o3

•jf , increase in
competition (or
reduction in
Tariff)
-o"o4
5Q, reduction in
Public expenditure,

o'i9

o o4

-o-oi

o*o7 -o-o3

o-i7

2. Ragnat Fiisob : A Memorandum on Prici-vYage-Tax-Subsidy Policies as
Instruments in Maintaining Optimal Employment. —The Univerüty
Institute
oj
Ecimmiis, Oslo ; Published as a U. N. Ducumsnt, April 1949.
3. W. Leontief :
by II. S. Ellis, 1949.

-o'i8

-0*005 -O'OII

-o*o5 -o'ooi -o"o4

-o"o2

-o"i9

-0'O02 -0*002 -0"Ol4 -o'oo6 -o.oo7

The meaning of these results is that
I. the necessary surplus for investment, abroad is within the
range of real possibilities except in the case (5) where it
surpasses the boundary value o"oi (the desired increase
in output) ; but the shift io domestic employment due to
such investmen t> ^.^^j-fi to 4t. quite small particularly in
,,.;
cases (4) and (6) ;

Eeoit)mctrUs—'&\a\dii.m, N. Y. iQS', (pp. 161-190)

"Econometrics", A Survey of Contemporary Eoonomios—Edtd.

4. J. Maischak : "Statistici! Inference in Economics ; An Introduction",
Statistical Inference in Dynamic Eccnotnic Models,'E.ilA.hj T. C. Koopmans. 1950.
5. T. C. Koopmans, Rubin, etc. : "Measuring the Equation Systems of
Dynamic Ecunomics", StJiisticcl Inference in Dynwiii
Eccnimic Models, Edtd. by
T. C. Koopmans, l95o.
6.

First Report cf the National Income Committee (of India), April 19S1.

7. Five Year Plan—A Draft Outline, Planning
India, 1951.

Commission, Government of

The auihor grat=fully acknowledges" receipt from Prof. K. Nagabhushnam and
Ui. N. S. R. Sastry important suggestions and criticisms in the preparation of this pjper.

J

/

m