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Change tax structure to boost growth
December, 01st 2012

The many vagaries of the economic scene appear to have much decelerated the growth momentum for many months now. And the latest growth numbers point at further slowdown, although there are tentative signs of sectoral turnaround. When the chips are down, it pays to chalk out policy design to boost output, employment and incomes across groups, segments and regions. Consider, for instance, tax policy, against the backdrop of hugely overextended government finances (read high fiscal deficit).

Also, the political consensus for a reformed indirect tax regime that involves an integrated goods and services tax appears to be missing, although there are reports of some headway on that front of late.

A recent working paper at the International Monetary Fund does provide extensive cross-country empirical evidence to show that raising taxes on incomes while reducing consumption and property taxes is negatively associated with growth. And increase in consumption (read retail taxes), compensated with a reduction in income taxes actually has a positive effect on growth.

The IMF paper does corroborate the need to fast-forward reform in the indirect tax regime. It would require Constitutional amendment so that the states are able to levy service tax and the Centre garners taxes along the entire value chain involved in the making of goods and services, with setoffs available for the taxes already paid in the process. The idea is to wholly avoid cascading tax rates or tax on tax and greatly boost transparency, improve administration and add to tax buoyancy in the bargain.

It makes ample sense. The mavens have indeed shown in recent growth models that tax-policy changes can and do affect the rate of capital accumulationboth of the human kind (read skills) and the physical variety, the workleisure tradeoffs, and thus impact growth.

Also, the stylised constructs do suggest that the effects can well be long-lasting, meaning that by following proactive tax design, the macro variables are suitably affected not just during the short to the medium term but in the secular period as well.

The fact remains that tax policy changes have led to long-term changes nationally. As expected, direct taxes on incomes of corporates and individuals now account for the bulk of the tax corpus and indirect taxes such as excise and customs make up for a lower share. The paper investigates the relationship between tax structure and long-run growth, using a rather comprehensive dataset that covers both high-come and lower-income economies for the period 1970-2009. The study uses regression analysis to work out the empirical relationship between tax composition and growth.

Whats surmised is that theres a robust and positive association between value-added taxes or consumption taxes on growth. For instance, a percentage point increase in income taxes, while reducing consumption taxes by the same amount, is shown to lead to a slowdown in growth of almost 0.2 percentage points on a long-run basis. The way ahead is to reform our consumption tax regime to rev up growth. (Tax Composition and Growth: A Broad Cross-Country Perspective, IMF, October 2012)

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