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Consumption tax hit poor harder and hurt growth
January, 14th 2014

Contrary to claims by BJP prime ministerial candidate Narendra Modi, the acceleration in India’s GDP growth since middle of 1980s has gone hand in hand with the rise in direct taxes (personal and corporate income tax) and cut in indirect taxes such as customs, excise, service and sales taxes. At their peak, government collected nearly a tenth of the GDP as indirect taxes in 1988, the ratio declined to 5.6% FY13. Conversely, the recent deceleration in economic growth has been accompanied by an increase in indirect taxes and decline in share of direct taxes in the government total tax kitty. (See chart)

In last four years, the share of indirect tax in central government total tax kitty increased from 39.2% in FY10 to 46.9% last fiscal and there has been a corresponding fall in the contribution from direct taxes. India’s GDP growth during the period declined from 8.6% in FY10 to 5% last financial year according to figures from the Reserve Bank of India.

Since 1991, India gross domestic at current prices (including inflation) grew at compounded annual growth rate (CAGR) of 14% against 11.4% CAGR growth in indirect tax collection during the period. The direct tax collection during the period expanded at the rate of 19.6% allowing union government to raise tax to GDP ratio without hurting growth.

Adjusted for inflation, GDP grew at a CAGR of 6.6% since 1991, much faster than 4% buoyancy in indirect taxes during the period. Direct tax collection on the other hand expanded at a CAGR of 12.3% post 1991. Indirect taxes are also inflationary in nature. For example from 1981 to 1991 when indirect tax collection (16.3% CAGR) grew faster than direct taxes (14.3%), inflation was much higher during that decade than post 1991. (See table)

Economists are not surprised at this inverse link between indirect taxes and the economic growth. “Indirect taxes are like an across the board consumption tax that hit poor more than rich. As poor devote a higher share of their incremental income to consumption, a greater share of their income is spent on taxes than rich whose consumption to income ratio is lower. This lowers overall demand in the economy economic growth suffers,” says Devendra Pant, chief economist and head public finance at India Ratings.

In contrast, direct taxes such personal income taxes are progressive in nature with higher earners paying more taxes than those at the lower end of the income pyramid. And majority of the people escape the tax as their income is below the threshold level where income taxes kicks-in. Businesses on the other hand pay corporate income taxes only if they make profits and enjoy tax breaks for capex in the form of rebate on depreciation allowances and interest payments. This encourages capital expenditure that helps economy to grow faster.

Indirect taxes such as excise, custom, sales and service taxes on the other hand, had to be paid regardless of a firms’ profitability. This hurts companies during economic slowdown when demand is down and customers hunt for bargain. “An efficient tax system aid economic growth while infirmities in the taxation systems hurts investments and growth,” says Indranil Pan, ?chief economist at Kotak Mahindra Bank.

Direct taxes while economically efficient are tougher and costlier to collect than indirect taxes that are collected at the point of economic activity –production (excise & service tax), trade (customs duty) and purchase (sales taxes). An efficient direct tax administration on the other hand require detailed database on income and expenses of every taxes payers –both individuals as well as business – and network of offices and manpower across the country. “Given the amount of effort and information required to efficiently collect taxes, direct taxes will always have some leakages,” says Pant.

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