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Increase in the tax-GDP ratio
September, 22nd 2009

One way that the demand of the fiscal conservatives can potentially be satisfied is by raising the ratio of revenues to GDP, primarily through an increase in the tax-GDP ratio. It must be noted that one of the creditable features of the rapid growth since 2002-03 in the Indian economy was that the long-term tendency for the tax-GDP ratio to stagnate or even decline was reversed.

A striking feature of the period since 1989-90 (which also marked the beginning of economic reform) till the early years of this decade was that despite evidence of higher growth rates and signs of growing inequality, there was no improvement in the Centres ability to garner a larger share of resources to finance expenditures it considered crucial. Even when corporate profits and managerial salaries were reported to be rising sharply, taxes were not buoyant. In fact, the Central tax- GDP ratios in India were declining for much of this period.

The tax-GDP ratio in India was also low by international standards, including those of many developing countries. The ratio of Central Government tax receipts to GDP was only 7.9 per cent in 1989-90; by 2001-02 it had fallen to a miserable 5.9 per cent. Even if taxes levied by the State governments are included, the total tax-GDP ratio was still only 15.9 per cent in 1989-90 and fell to 13.8 per cent by 2001-02 (Chart 3).

This compared poorly with tax-GDP ratios in most developed and developing countries. India is by no means an overtaxed country, but has much fiscal space to expand its revenues.

It is true that in the case of India and many developing countries internationally quoted figures are not comparable with that for the developed countries because they exclude taxes collected by state or provincial governments. But the figures quoted above, which include State revenues, do not tell a very different story.

However, between 2001-02 and 2007-08 the tax-to-GDP ratio at the Centre rose from 5.9 per cent to 9.3 per cent. The aggregate tax-GDP ratio of the Centre and the States rose even more sharply from 13.8 to 19.1 per cent between 2001-02 and 2008-09.

It must be noted that the period after 2002-03 was one in which profits in the organised sector rose sharply, the ratio of profits to value added also rose significantly and saving and investment rates in the corporate sector recorded sharp increases. This was, therefore, a period when high growth was accompanied by significantly increased inequalities in the organised sector, leading to the rise in the tax-GDP ratio.

Not surprisingly, there has been a significant shift in the relative contribution of different components of taxes to the tax-to-GDP ratio at the Centre over the years. Liberalisation involving a reduction in Customs tariffs and a rationalisation of the indirect tax regime resulted in a decline in the tax-to-GDP ratio between 1989-90 and 2001-02.

Customs and excise duties contributed 86 and 55 per cent respectively to the decline in the central tax-to-GDP ratio during those years. On the other hand, corporate taxes, other income taxes and service taxes contributed 71, 25 and 30 per cent respectively to the increment in the central tax-to-GDP ratio between 2001-02 and 2008-09. Thus, higher tax collections from the industrial sector, better off individuals and a widening of the tax net accounted for the improvement in the Centres revenue base.

Interestingly, at the central level this rise in the tax-GDP ratio was beginning to reverse itself even by 2008-09. If that trend persists then the deficit in the Central Budget would only widen. There is reason to believe that this could occur.

Net direct tax collections during the first three months of fiscal 2009-10 (April-June) recorded an increase of 3.65 per cent, as compared with a budgeted increase of 9 per cent for the year as a whole and a much higher 38.6 per cent during the corresponding quarter of 2008-09.

The fear that this could encourage the government to increase tax rates, impose surcharges or reduce exemptions possibly explains in part at least the clamour for an exit from a near non-existent fiscal stimulus programme. This could worsen and aggravate the slowdown in growth, already threatened by a drought.

On the other hand, if the current tendency for the tax-GDP ratio to rise can be sustained through additional taxation measures, the fiscal situation is by no means dire. However, there is reason to believe there is a backlash against the tendency of the Government to enhance its revenues by increasing resources garnered through taxes on profits and higher income group incomes.

Direct Taxes Code

In what seems to be an effort to compromise with that tendency the Government has proposed in its new Direct Taxes Code a drastic scaling down of tax rates and a restructuring of tax slabs, arguing that this would simplify the direct tax regime and prove revenue enhancing because of reduced exemptions and better compliance. But there are many who believe that this is merely a step towards reversing the rather remarkable increase in the direct tax-to-GDP ratio seen in recent years.

We must recall that between 2001-02 and 2007-08, when the Central gross tax revenue-to-GDP ratio rose by 4.4 percentage points from 8.21 per cent to 12.56 per cent, the fiscal deficit-to-GDP ratio fell by 3.5 percentage points from 6.2 per cent to 2.7 per cent.

That is, much of the improvement in the fiscal position of the Central Government was because of a faster increase in its tax revenues relative to GDP. In 2008-09, not only was the rise in the tax-GDP ratio halted and marginally reversed (by 0.8 of a percentage point), but the ratio of expenditure to GDP rose by 1.8 percentage points on top of a one percentage point rise the previous year.

In the current year too, this rise in expenditure is likely to continue and what the Government should look to is to restore the rise in the tax-to-GDP ratio.

If it can achieve that, both growth and fiscal stability would be ensured. But the attention of the fiscal conservatives seems to be focused on expenditure reduction, which is not recommended at all in the current circumstances.

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