The avoidance of taxes is the only pursuit that still carries any reward, Keynes is known to have warily remarked. These days, the tax systems the world over are more efficient than in the past because the tax rates are generally far lower on all forms of income.
But the marginal tax rates on additional income remain by and large high, including here in India. This implies untoward distortions in the tax regime, which the budget would need to correct. Also, a panoply of tax benefits and write-offs mean substantial costs in terms of revenue foregone. So, streamlining and rationalisation of tax incentives are needed.
The big picture is that tax revenues measured as the ratio of tax to GDP are buoyant and rising around the globe, including in the mature economies where the ratio is generally high thanks to high incomes and better compliance.
A recent study of the high-income OECD economies found that despite deep cuts in tax rates, the tax to GDP ratio is actually on an upward trend reflecting the effects of stronger economic growth, which has led to higher corporate profits, and also because of moves to offset the effects of tax cuts by broadening the tax base. The figures for 2005 suggest that the tax burden as a proportion of GDP in the OECD area has inched up to 35.9%.
In India there has been extensive tax reform in the last decade and a half. The general trend has been to reduce tax rates and to change the tax structure itself. Direct taxes on income now constitute over almost 4.5% of GDP, a smart improvement from barely 2% back when reforms began. Given that direct taxes are accepted as more progressive in the cannons of taxation, the change is surely in the right direction of reforms. Direct taxes now account for over half the total tax effort. Also, direct tax rates have significantly dropped over the years, which no doubt have improved tax buoyancy and compliance.
However, effective tax rates remain quite low and so there is much scope to rationalise tax exemptions. Also, marginal tax rates on income remain steep and clearly need to be reviewed for the greater good.
As for indirect taxes like customs and excise, the strategy has been to simplify tax structure by reducing rates and their multiplicity. With cenvat now covering most of the commodities subject to Union excise duties on manufacturing and tax credit provided for service tax paid on inputs against cenvat, many of the earlier distortions of cascading tax rates have been removed. Further, the change over to VAT when it comes to consumption and sales, with taxes paid only on the value added, has improved compliance and revenue collections at the state level. Overall, the tax to GDP ratio (taking the Centres and the states together) is on the rise due to tax buoyancy although, perhaps, still less than 16.1% reached in 1988.
The sharp reduction in excise and custom duties in recent years have reduced collections, especially on the former head and lowered the tax to GDP ratio. The substantial collections in service taxes, up from zilch just over a decade ago, has also added to the indirect tax kitty. What is clearly needed now is further reform, a widening of the tax base and lowering of rates to make import tariffs, for instance, no more than Asean levels.
High marginal tax rates on income distort compensation and unduly encourage spending on tax favoured forms of consumption. The Indian experience is that there is a large elasticity of taxable income with respect to the net of tax rate. In other words, lower tax rates do shore up tax revenues.
So, high relative marginal tax rates imply loss of revenue and a deadweight loss for the economy. The tax on capital income such as those on bank deposits further reduce consumption. The combination of taxes on corporate profits, dividends and capital gains, all imply efficiency costs and depress tax revenues in a myriad ways. The way ahead is lower rates generally rather than a long and growing list of exemptions and tax breaks.
Tax concessions, deductions and most of all, tax holidays, after all are rather inefficient and costly instruments of public policy and do need to be confined to only a few select activities which promise substantial spillover effects and economy-wide gains such as research and development.
A recent NIPFP study found that tax exemptions on a variety of questionable heads such as export incentives, area-based concessions, those on charities with profit income, agricultural income generally, tax breaks on real estate, small-scale industries and several commodity based write-offs on excise and customs, all added up to no less than Rs 54,560 crore last year. The tax breaks do need to be urgently reviewed.
Take housing, no doubt a priority area. But apart from the tax incentives and deductions on loan repayment and interest, it needs to be asked why real-estate developers need a total tax holiday under section 801B (10) of the Income-Tax Act. The expert opinion is that there is a revenue loss of almost Rs 10,000 crore on this head alone! It can lead to wholly inefficient allocation of resources.