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Towards an efficient tax system
October, 03rd 2009

The competitiveness of our economy in general and industry in particular hinges on a system of taxation which, through its progressive approach, optimises revenue consistent with stimulating industrial activity and consequently growth in our economy. The tax system should be fairly efficient while effecting revenue mobilisation in response to growth.

And the tax system is efficient if it is income elastic so that revenue grows slightly faster than GDP. How does India fare in this regard? How far has revenue increased in response to reform in tax system in the post-liberalisation period?

Let us first begin with direct or corporate tax. The post-liberalisation period has witnessed a significant change in the structure and composition of taxes levied on corporates. We have come a long way from the earlier regime wherein direct taxes were exorbitant and suffered from multiplicity of rates.

There has been a sustained move towards lowering of tax rates. The corporate tax rate has come down from 40% in 1994-95 to 35% in 1997-98 and is 30% at present. The number of tax slabs has also been reduced to three.

Preliminary investigations indicate that yield from corporate tax has increased in the post-liberalisation period. The decline in tax rates has improved compliance which together with a rise in growth rates has made a positive impact on revenue mobilisation. The yield from corporate tax with respect to GDP has gone up from 0.9 % in 1990-91 to 1.7% in 2000-01 rising to 4.3% in 2008-09.

Besides, during the economic upswing of 2003-2007, when economic growth was in the vicinity of 9%, the corporate tax to GDP ratio doubled from 1.9% in 2002-03 to 4.1% in 2007-08. However, tax collections as a proportion of GDP have remained steady in 2008-09 even as ongoing economic slowdown has affected manufacturing output.

Corporate data reaffirms that tax reform has also not made a major dent in government revenues. This is evident from the fact that the share of corporate tax in profit before tax of corporates has been fairly stable, hovering around 20-25% during most of the post-liberalisation period. In fact, the ratio of corporate tax to profit before tax, as per data available with CMIE, declined from 24.9 % in 1990 to 21.6 % in 2004-05 rising marginally to 22.3% in 2007-08.

Here it may be noted that corporate tax-to profit-before tax is much higher for foreign companies than for the Indian private sector. This may be because the tax rate on foreign companies is much higher at 42.23 % as compared to 34% (including surcharge and education cess) for Indian companies.

Another fall-out of the reform process is that tax collections have exhibited a certain amount of buoyancy in response to a rise in GDP. This becomes apparent as the elasticity of corporate tax collections measured by the ratio of percentage change in corporate tax revenue to percentage change in manufacturing GDP at current prices has surged from 0.8 in 1990-91 to 1.3 in 2005-06 rising to 2.3 in 2006-07 and 2007-08 indicating an increase in revenue mobilisation in response to growth. However, latest comparisons show that buoyancy has gone down to 1.06% in 2008-09 due to economic slowdown. Similarly, elasticity of indirect tax collections has also dropped in 2008-09 as compared to the previous year.

In fact, in the case of indirect taxes, the revenue from Union excise duty as a proportion of GDP has experienced a fairly secular decline even when the economy was doing well: from 4.3% in 1990-91 to around 2.6% in 2007-08.

Similarly, the share of customs duty collections has also declined from 3.9% to 2.2% during this period. And the figure has dropped to 2% for 2008-09. This has happened even though the peak rates of both customs and excise are hovering around 10% and 8 %. Indeed, the country is moving towards a regime where direct taxes are contributing more to revenue as compared to indirect taxes.

Indeed, a fall in tax rates has led to a pick-up in yield in direct taxes to a little over 4% of GDP as compared to around 1.4% in mid-nineties. However, this is much lower than the 7-9% prevailing in most developed countries. Besides, the high incidence of excise burden 25% to 30% of retail price constrains demand. There is considerable scope for further raising tax yields and improving the elasticity of tax collections. This calls for further reforms in our tax system.

There is a need for moderating the tax rates and bringing it on par with countries such as Norway, Sweden, Malaysia, Thailand, etc., where the rate of corporate tax is around 25-30%. It is in this context that the proposed reduction in corporate tax rate to 25% with removal of exemptions, as suggested by the draft Direct Tax Code put up for public debate, assumes special significance.

There is a need for broadening the tax base and bringing more people into the tax net rather than nudging the same people to pay more. While the reform process has led to some broadening of tax base due to an increase in the number of assessees, the revenue realised is not appreciable. Presently, there is a heavy reliance on corporate taxes which have a share of 35% in total tax revenue.

The services sector, which has a share of around 56% of GDP contributes a meagre 10% of total revenue with many services outside the tax net. Agriculture income is also tax-free. As a result, the revenue foregone could exceed 50% of aggregate tax collections.

The lower yield from indirect taxes, particularly excise, is also a matter of concern as customs duty rate is seen more as an instrument of protection than that of revenue generation. Hence, improvement in revenue productivity of domestic excise collections by ensuring better tax compliance through improved tax administration deserves consideration.

The implementation of GST would also augment revenues by plugging leakages. A transparent long-term taxation policy is also needed to help investment planning.

Clearly, there is considerable scope for raising yield and improving the elasticity of tax collections. The time has come to move further in the direction of a simple, neutral and efficient tax system which encourages capital formation in industry even while ensuring a steady revenue stream for the government.

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