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Tax reform must involve a big shift in policy direction
December, 22nd 2009

Tax reforms are the flavour of the season. Whether it is the long-awaited introduction of GST (Goods and services tax) or the Direct Tax Code, the tax regime is headed for an overhaul of the kind not seen since the introduction of Vat (Value-added tax). Fittingly, the first Raja Chelliah Memorial lecture organised by National Institute of Public Finance and Policy in memory of the father of tax reform in India, Raja Chelliah, was delivered by another stalwart in fiscal economics, Professor Alan Auerbach, Director, Robert D Burch Centre for Tax Policy and Public Finance, University of California, Berkeley. The topic of his lecture? You guessed it! On the Adoption of Tax

You seem to favour large rather than incremental tax reform. But in noisy democracies like India where wholesale reform is much more difficult than incremental (which is why GST is proving so difficult) do you think there is a case for re-thinking that proposition?

There is a case for incremental reforms in some cases. The problems are that they are more easily reversed once adopted, and are more likely to create winners and losers and therefore be opposed in the first place. A large package of reforms, by contrast, may be constructed to benefit most individuals and harder to reverse. However, large packages are difficult and time-consuming to construct, so if there are small steps that are so beneficial that they can stand on their own, then these might be a successful route to reform, at least initially.

Youve also made a distinction between tax reform and changes in the tax system. Could you elaborate?

Tax reform involves more than changes in tax rates or other adjustments that may be seen as the normal evolution of a given system in response to year-to-year fluctuations in revenue needs and spending requirements. To be reasonably labelled as a tax reform, a change must involve a more significant shift in policy direction, such as the adoption of a new type of tax or a major change in the existing tax base.

What is the trigger for tax reform?

There could be a number of reasons. Change in the prevailing political consensus is one; gradual erosion of the tax system is another. Then you could also have some additional inputs coming from new information and of course there could be a change in circumstances that make a compelling argument for a change. In the US, for instance, the Tax Reform Act 1986, broadened the tax base but at low marginal rates of tax. Now we are seeing an erosion of the base and hence there is a call for higher rates.

Does sustainability of tax reform mean that countries have to wait to get everything right before they go ahead or can they improvise as they go along?

There is a trade-off; one shouldnt wait for the ideal if a reasonable potential reform is available, for waiting can deprive the economy of the benefits of reform during the interim. But the significant political capital required for a reform supports the argument for waiting until a major improvement is expected. It must be a matter of judgement when the time for reform has come, and of course political conditions will influence this timing as well.

How can countries make tax design impervious to rent-seeking?

There are blunt instruments for doing so, such as constitutional restrictions, but I favour choosing methods of taxation that are less susceptible by design, such as the subtraction method VAT/GST versus the credit-invoice method practiced in most countries. Whereas the credit-invoice method keeps track of individual stales and therefore makes differentiation in tax rates a straightforward procedure, the subtraction method does not.

Given that FDI is much more beneficial than portfolio flows, is there a case for some kind of tax on inflows?

I would favour instead tax benefits targeted toward FDI, but these two policies have the same effect of favouring FDI over portfolio flows.

In one of your papers youve called for new fiscal activism. What do you mean by that?

I think the approaches to fiscal stimulus undertaken in most countries in the past year were not sufficiently informed by recent advances in economic theory and analysis. For example, governments could have used timing incentives more, as through temporary sales tax reductions, to encourage more aggregate demand at relatively little cost in tax revenues.

In the present context should we see an exit from expansionist fiscal policies first or from easy monetary policies?

I think this must depend on the country in question and what the inflation outlook is there. Where the risk of inflation is small, low interest rates can be maintained.

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