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Valuing good taxes
January, 12th 2012

Raising revenue for fiscal consolidation will require hikes in indirect taxes.

In drafting the Union Budget for 2012-13, the government will have to consider how to return to a path of fiscal consolidation. This is still a phase of expanding populist spending, but the fiscal space has shrunk greatly. Fiscal soundness must, therefore, involve reducing the waste in government expenditure. This will have to be accompanied by attempts to raise more revenue, whose share of GDP has shrunk in recent years. Raising revenue is complicated by two things: the fragility of the economy, and political constraints that make meaningful alterations to direct taxes difficult. The government will be forced, therefore, to examine indirect taxes and the central value-added tax, or Cenvat, in particular. The modal Cenvat rate before the Budget for 2008-09 was 16 per cent. That Budget cut the rate to 14 per cent; then the various VAT rates were cut by a further four per cent after the financial crisis of 2008 hit, as part of the first post-crisis fiscal stimulus. The Budget of 2009-10 took the cuts even further, taking the modal Cenvat down to eight per cent. Although the pressure to roll back the fiscal stimulus was considerable last year, Finance Minister Pranab Mukherjee moved the rate up by only two percentage points. This years Budget cannot afford to pause in its attempt to return to a pre-crisis fiscal path. Another increase in Cenvat by two percentage points, to 12 per cent, is what the situation demands.

In addition, those segments of each sector that are considered luxuries can afford the burden of a further impost. In most product categories, the highest end survives recessions better; demand that is robust is a better location for tax rate hikes. Special excise duties, thus, are a good mechanism for raising revenue, with minimum distortions to the economy. The question of how to define luxury goods should not be a problem: vehicles with engines above a certain cubic capacity, television sets above a defined size, refrigerators above a given number of litres. A tax on final products will avoid a cascading effect, which is particularly important when the economy is still subject to some inflationary pressure.

No one likes higher tax rates, and a period when the economic tempo has slackened is not ordinarily a time for raising taxes. If this newspaper is nevertheless recommending them, it is because even a higher rate of 12 per cent will be lower than the level that prevailed till 2008, because fiscal control is essential for returning to a higher growth path, and because it is evident that no substantial trimming of the fiscal deficit is possible without higher rates. In particular, the government is not anywhere near close to big-bang tax reform as could have been hoped. The goods and services tax (GST), planned for April 2010, is still nowhere on the horizon with Opposition-ruled states in particular reluctant to co-operate. The goal of raising tax revenue cannot wait indefinitely for the GST. In any case, even a GST regime that is revenue neutral on a 2008 basis would require higher tax rates.

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