It is trapped between nations that get a lot of foreign aid and the ones with strong tax collections

Most citizens pay direct taxes in successful democracies, but not so in India—partly because of high levels of poverty but also because of rampant tax evasion.

In this context, some recent statements on direct taxes are worthy of notice. Arun Jaitley predicted earlier this month that India can have around 120 million tax payers as more Indians become part of the formal economy. His top direct tax officer has said that the number of people filing income tax returns in the current assessment year is already at around 60 million, or 50% higher than the previous year. Central Board of Direct Taxes chairman Sushil Chandra believes this is the dividend from demonetization.

The finance minister is thus predicting a doubling of the number of income tax payers in the coming years. Here is a simple calculation to help us think through these numbers. India has around 250 million families, more than half of whom will anyway be outside the tax net either because they are farmers or they are too poor to pay taxes. That leaves around 125 million families that can potentially pay income tax. Jaitley is implicitly suggesting that most Indians who should be paying taxes will be doing so soon, even if you adjust for the fact that many families will have more than one taxpayer. However, it is important to remember that a tax filing is not the same as a tax payment, and many Indians who file returns do not actually report any tax liabilities.

Are these credible forecasts? The fiscal muscle of the Indian republic has been a running theme for this column. For example, I had commented on the persistent poverty of the Indian state in December 2016 and had asked in January 2018 whether India is on the cusp of a fiscal revolution. I had then presented data that income tax collection as a percentage of gross domestic product (GDP) tends to rise sharply once average incomes cross the $2,000 threshold—from 1% of GDP to around 5% of GDP. The statements by senior government officials over the past few weeks makes that question resonant again. Meanwhile, the government will begin work on a new direct tax code that will seek to deliver a stable tax regime, even if tax rates are not actually brought down.

Why should all this matter? A new paper by Lucy Page of the Massachusetts Institute of Economics and Rohini Pande of Harvard University, published in the new edition of the Journal Of Economic Perspectives, provides a good framework to understand why the fiscal deepening of the Indian state is important now. The two economists have marshalled a wealth of data to show that neither faster economic growth nor foreign aid will suffice to end extreme poverty by 2030. “To end extreme poverty sustainably and as quickly as possible, the states governing the world’s poor need to be strengthened such that they are both accountable to the needs of the poor and have the capacity to meet those needs,” say Page and Pande.

One of the ironic economic facts today is that most of the poorest people in the world live in countries such as India that are classified as middle income countries based on average incomes. These countries are unlikely to get enough foreign aid but they do not have the deep fiscal resources to help their poor either directly through redistribution or indirectly through the provision of public goods that will raise their ability to earn extra income. Countries such as India are thus trapped between the very poor countries that get a lot of foreign aid and the wealthy ones with very strong tax collections.

The Indian state has historically battled immense fiscal constraints. The economic historian Tirthankar Roy has showed that even in the colonial era, the tax collected for every unit of economic output in India was minuscule compared to not only colonists such as Great Britain or an Asian success story such as Japan but even colonized countries such as Malaysia or Sri Lanka. The government of what was then the Federated Malay States spent on average more than 10 times the money spent in British India per head between 1920 and 1930.

There are three important consequences of getting more people into the direct tax net. First, the overall boost to tax collections means that the Indian state will be in a better position to perform its key duties without running into repeated fiscal crises.

Second, higher direct taxes could provide space for significant cuts in indirect taxes such as the goods and services tax, which in effect means a shift from a regressive to a progressive tax system.

Third, a widening tax pool because of formalization means the current perverse system in which efficient firms are taxed at a high rate because inefficient firms manage to slip outside the tax system will end.

The recent trends in direct taxes offer hope but are too preliminary to jump to any conclusion. What is not debatable is the profound effects—both economic and political—they can have in case reality matches expectations.

Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute.