Higher direct tax collections could lower the tax burden on the poor by creating fiscal space for a reduction in GST rates

The second round of the great Indian tax overhaul has been flagged off. The Narendra Modi government has appointed a committee headed by Arbind Modi to review the Income Tax Act of 1961. This is a welcome move, and comes in the wake of the—admittedly rocky—transition to a new indirect tax regime with the introduction of the goods and services tax (GST). As we will explain later in this editorial, a new direct tax system could help lower GST rates in the future.

The existing direct tax law is riddled with problems. It is extremely complicated, has ambiguities that create an excess of litigation, offers scope for administrative discretion that is often the fount of corruption, imposes high costs of compliance that especially hurt those with lower incomes, and has many exemptions that hurt allocative efficiency by distorting the decisions of participants in the economy. A clean direct tax code—which will cover income tax, corporate tax, dividend distribution tax, fringe benefit tax and wealth tax—should help promote economic efficiency as well as protect horizontal and vertical equity.

Arbind Modi is a good choice to head the committee that will take a fresh look at the direct tax system. He was one of the brains behind the Direct Tax Code prepared in 2009 which, unfortunately, did not make it to Parliament. Some of the principles that were proposed to be embedded in that document need to be reiterated.

All direct taxes were to be brought under a single code with unified compliance procedures. The code was drafted in simple language to minimize ambiguities; every subsection was a short sentence to convey a single point. The code aimed at flexibility by keeping only general tax principles in the law, while details were found in the income-tax rules. The uncertainty on tax rates after every Union budget was to be dealt with by stipulating tax rates in the code itself, and these could be amended by Parliament. Taxes would not be used to meet regulatory goals, which were best served by the new sectoral regulators who have been put in place over the past two decades.

A new direct tax system can serve two very important political economy functions. First, it is no secret that too few Indians pay direct taxes. There is only one Indian filing annual tax returns for every 16 voters, and the fact that millions of voters do not earn income because of their age or gender is balanced by the fact that not every person who files his tax returns actually pays tax. As we argued in these pages earlier, this asymmetry between direct tax payers and voters has created a political system that quite naturally cares more about spending to buy votes rather than building a more effective tax system that will spur economic growth.

Second, the inability to grow the direct tax base rapidly enough—and this is what a cleaner direct tax system can achieve—has meant that the Indian state has to depend a lot on indirect taxes, which are fundamentally regressive. That is true even in the case of a value-added tax such as the GST. Almost nine out of every ten rupees collected by the government before the economic reforms came from regressive indirect taxes, a testimony to the hypocrisy of Indian socialism. There is a far better balance between direct and indirect taxes now, thanks to the tax reforms of the 1990s, but the proportion of direct taxes in the total pool has to increase further to make the tax system more progressive.

A clean direct tax code will help achieve three key goals. First, it will help make the Indian economy more competitive through tax stability, minimal exemptions and the focus on allocative efficiency. Second, it could alter the Indian social contract by increasing the number of people paying income taxes. Third, higher direct tax collections could lower the tax burden on the poor by creating fiscal space for a reduction in GST rates.

The focus right now should not be on lowering marginal tax rates, other than the commitment to bring down the corporate tax rate to globally competitive levels, but on increasing the tax base through a better direct tax system.