Tax Administration Reform essential for improving Public Financial Management
August, 09th 2014
The importance of professional competence in Public Financial Management (PFM) has risen due to several factors. First, the 2008 global economic crisis, whose consequences are still being felt, has reduced the medium term growth prospects globally, and has undermined the assumption that sovereign entities routinely have the lowest credit risk. As tax revenue is highly correlated with economic activity, slower growth has meant lower revenue generation. Rethinking of sovereign risk has led to rising costs of public debt rollovers and servicing.
Second, globalisation has reduced tax policy autonomy of even the large economies, reflecting in greater sensitivities of business and individual location decisions. Recent concerns about “tax inversions” leading US corporations to shift their headquarters to other countries providing better tax and business environment illustrates the point.
Third, expenditure needs are growing due to population ageing and associated pension and healthcare costs; technological changes which make generation of good jobs even more challenging and requiring higher Government expenditure; and expenditures associated with provision of infrastructure and other amenities to keep economies competitive and to meet rising expectations of the population.
PFM Reforms in India
Reforming India’s PFM is an important objective of the Prime Minister Narendra Modi-led Government which assumed office towards end May 2014. This is because the main economic priorities of the 2014-2015 Budget to raise economic growth rate, while keeping inflationary pressures at manageable levels; achieve fiscal consolidation i.e. reducing revenue and fiscal deficits; and fiscal flexibility (reallocating expenditure towards current economic policy goals) and generating productive livelihoods in large numbers relatively quickly, cannot be achieved without significantly reform the PFM, and substantially increasing the competency and effectiveness of the relevant organisations.
India’s GDP in 2013 was about Rs 120 Trillion ($2 trillion). Assuming India’s nominal GDP grows by 12 per cent (6 per cent real growth and 6 per cent inflation), India’s nominal GDP will quadruple in 12 years (by 2026) to RS 480 trillion ($8 trillion).
In 2012-13, India’s combined Union and State Government expenditure and tax revenue were 26 per cent and 16 per cent of GDP respectively. Thus, in 2012-13, per person Government expenditure and revenue were RS 23,000 and RS 14, 000 respectively. If the GDP growth rates assumed above hold, and similar ratios as in 2012-13 prevail, by 2026, per capita expenditure and taxes will be RS 92,000 and RS 56,000 respectively.
The above figures suggest that taxes finance only about two-fifths of the total expenditure, a ratio which needs to be increased, but through higher economic growth and base broadening rather than raising tax rates.
India is now much more integrated with the global economy in trade in goods and services (in 2012, India’s total international trade in goods and services was $1059 Billion, equivalent to 58 per cent of its GDP); investments, technology, tourism and manpower flows (India was the largest recipient of remittances at about $70 billion in 201 ). As the Narendra Modi-led Government succeeds in making India more competitive such global linkages can be expected to grow.
There are two major implications of the above trends. First, there is justifiable disappointment with the fact that in spite of Government obtaining from the citizens relatively large share of nation’s GDP, quality and quantity of public services available to the citizens is not commensurate with it. Reforming PFM is essential to address this major deficiency eroding trust between the Government and the taxpayers.
The second implication is that the growing size of the economy and deepening linkages with the global economy requires a much more professional and competent approach to PFM than has been the case so far. Existing tax and spending organisations of the Government at the Union, State, and Local levels are simply not equipped to meet the demands on them by the stakeholders.
The PFM reform cover wide area, including raising financial resources, including from taxes, user charges, auctions, and other methods; and Government expenditure management which contributes to spending less for a given item, spending well, with reasonable relationship between output generated and financial and other inputs; and spending wisely, i.e. attaining desired societal outcomes from Government programs and schemes.
There are other elements of PFM, including accounting methods and budgeting systems; and increasingly crucial role of supreme audit institutions in advancing value-for-money auditing in the Government.
Reforming India’s Tax Administration
The focus of this article is however on reforming tax administration, only one of the components of PFM.
There has been widespread concern that the current organisations and systems of tax administration and compliance require fundamental reform. The economic costs to the society, including costs of compliance by the taxpayers and distortions in economic decision making due to inconsistency in tax administration procedures, poor design of tax laws and regulations, inappropriate skill sets and work process of tax organisations, and insufficient use of technology, are regarded as disproportionate to the tax revenue obtained. The tax system and its administration are also widely and correctly perceived to leave substantial scope for improving fairness.
The first Budget of the Prime Minister Narendra Modi-led NDA (National Development Alliance), presented on July 10, 2014, and recognises the importance of enhancing trust and confidence of the tax payers in the organisations involved in tax administration, particularly in those administering income tax, service tax, excise taxes, and customs taxes.
The key points of the Budget proposals concerning tax administration, contained in paragraph 10 to 15,204 and 209-210 of the Budget Speech, may be summarised as follows:
» The damage to India’s investment climate and competitiveness due to retrospective taxation measures introduced in 2012 are recognised. The proposal is that any fresh cases under these provisions are unlikely to be pursued, and ongoing cases will be brought to a closure expeditiously.
» Some analysts would have preferred the retrospective tax features to be withdrawn. But this view has not been reflected in the Budget. It is hoped that in the future, drafting of tax laws and implementing regulations will be undertaken with greater care, keeping in mind the need to encourage maximum voluntary compliance. This is recognised in part as the Budget expands the scope of Advanced Tax Rulings, under which tax implications of a proposed transaction can be established in advance of the decision.
» The Budget has recognised that India’s Transfer pricing regulations need to be made more consistent with international practices (Para 204). The consequent Amendments are expected to bring greater clarity in international taxation.
It would be useful to consider developing specialists in international taxation within the tax organisations, with appropriate longer term tenure and work environment. These organisations should be encouraged to network internationally, particularly with the tax forums of the OECD. India needs to review its Double Taxation Avoidance Agreements entered into with many countries as these were negotiated when India’s economic size and its international linkages were relatively modest. This requires specialists in different areas, including law, and international economics.
» The Budget expresses concern that tax demands of more RS 4 trillion (equivalent to 3.6 per cent of GDP) are under dispute and litigation. (Para 11).
» The Budget hopes that the Income- tax Department would transform itself from being just an enforcer of tax regulations to a facilitator. The Budget proposed 60 more Aykar Seva Kendra (ASK) across the country during the 2014-15 financial year (Para 209).
» Transforming an Income Tax (or any other Tax) Department accustoms for decades to relaying on the statutory powers to a service- oriented facilitator is however a difficult exercise requiring skills in managing organisational change.
» The 2014 Budget has begun the exercise to address perverse duty structures under which imports were given preferential tax treatment over domestic goods and services. The tax anomalies created by not always well thought out preferential trade agreements with various countries also need to be addressed. Introduction of GST could be an occasion to address them.
The focus of the 2014-2015 Budget on bringing greater clarity and competence to tax administration, and on reducing compliance costs of taxes is welcome.
Further Reform Initiatives
However, as the first Report of the Tax Administration Reform Commission (TARC), submitted on May 30, 2014, emphasises, there is a need for far reaching changes in the spirit, purpose, organisational structures, skill sets, internal work processes, external communication and dispute management of tax organisations involving both direct and indirect taxes. Greater synergy between the two (including sharing of certain services to save costs), and emphasis on functional specialisation in their activities are needed.
The two major pending tax initiatives, Goods and Services Tax (GST) to replace plethora of sales and related taxes levied by Union and State Governments, and the Direct Taxes Code (DTC) modernising income tax laws and regulations, should also be reviewed and where appropriate modified to be consistent with the reforms in tax administration suggested above.
Revisiting DTC provisions with a view to improving business and individual tax friendly environment in India therefore should be regarded as an essential part of improved economic management and governance.
There is also a need to review the Companies Act 2013 with the objective of minimising compliance costs of the companies, and ensuring greater clarity on rules with tax implications (such as mandatory spending on Corporate Social Responsibility, (CSR)
The focus of modern professional tax organisations should not primarily be on revenue collection. It should instead be on creating a tax organisational culture and environment in which maximum voluntary tax compliance occurs. This requires, among others, tax rules and regulations which are sensitive to economic and commercial conditions, and which are system-oriented and not individual- oriented.
Among the most important factor generating tax revenue is the level and growth of economic activities which in turn impact on the tax bases. Thus, tax administration should not be a hindrance to legitimate economic activities.
In India, there is considerable potential to increase the number of tax payers for each tax, and the proportion of true tax base that is reported. Thus, it is estimated that currently only between 35 and 40 million individuals are active income tax payers in the country, when the potential under existing provisions is more than double that number. In many occupations, the proportion of true income reported ranges from 25 to 50 per cent, rather low figure.
Generating an environment and tax organisation ethos that encourages maximum voluntary compliance, supported by good tax design, and competent risk-based auditing is the direction in which tax administration reforms should be directed.
Thus, to expand tax base, a more effective and fair method to generate revenue, an empirical – evidence based approach to tracking the missing tax payers, and to improve the share of true-income reported for tax purposes is needed. Tax Research and Analysis Division (TRAD), covering all Union Government Taxes, therefore deserves consideration. The first report of TRAC has recommended. Tax Council and Tax Policy and Analysis Unit, with a broader mandate than what is suggested for TRAD.
TRAD could also be given the task to research on measures which could help expand effective tax base of other Union Taxes. It could also assist State level agencies in such a task. The concept of shared services in taxation to help minimise transaction costs of tax administration and to improve compliance rates also needs to be explored.
There is a strong case for not resorting to tax revenue targets, determined in an ad-hoc manner, without regard to economic costs and distortions generated. Such targets also adversely impact on the moral and organisational confidence of the tax officials. Instead, revenue projections need to be based on the basis of analytical methods, using modern revenue forecasting techniques. It is such revenue projections which should impact on expenditure level and composition, and not the other way round as appears to be the current practice.
In conclusion, as with many areas of governance, tax administration and compliance issues need to be addressed with much greater degree of professionalism, outcome- orientation, and taxpayers-citizen centric manner; and approached from a systemic rather than fragmented perspective.