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Meddling with taxes
September, 25th 2009

The government has tabled for debate a new direct tax code that it claims would innovatively combine lower taxes, substantially widened tax slabs and the removal of exemptions to institute a whole new tax regime. This gives rise to the question as why this change is being contemplated at the current juncture, especially since there is considerable disagreement on the impact that this would have on revenue generation. The government claims revenues would be more buoyant. Others such as fiscal experts from the National institute of Public Finance and Policy are more than just sceptical.

The conjuncture is indeed important. One of the creditable features of economic performance during the period since 2002-03 was that the prior, long-term tendency for the tax-GDP ratio to stagnate or even decline was reversed. The ratio of taxes mobilised by the central and state governments to the countrys GDP, which had touched a twenty-year low of 13.8 per cent in 2001-02 rose by 4.7 percentage points to 18.5 per cent in 2007-08. Almost 90 per cent of this increase was because of an increase in gross tax revenues at the centre from 8.21 per cent of GDP to 12.4 per cent.

This rise in tax-GDP ratios compares with the tendency over the period starting 1989-90 (which also marked the transition to economic reform) till the early years of this decade, when, despite evidence of higher growth rates and signs of growing inequality, there was no improvement in the governments 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.

This was particularly true of the central tax GP ratio. 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 5.9 per cent. If taxes levied by the State Governments are included, the total tax-GDP ratio fell by more or less the same proportion relative to GDP, from 15.9 per cent in 1989-90 to 13.8 per cent by 2001-02. These ratios also compared poorly with tax-GDP ratios in most developed and developing countries. India was by no means an over taxed country, but had 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.

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 57, 18 and 22 per cent respectively to the increment in the central tax-to-GDP ratio between 2001-02 and 2007-08. Thus, higher tax collections from the industrial sector and better off individuals and a widening of the tax net accounted for the improvement in the centres revenue base.

However, at the central level this rise in the tax-GDP ratio was beginning to reverse itself in 2008-09 from 9.31 per cent of GDP to 8.76 per cent. This happened in a year when enhanced expenditures had contributed substantially to widening the deficit on the Centres budget. If that trend persists then the central deficit would only widen further.

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.

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.

So, if the fiscal situation is the concern of the government, then the effort should be to restore the earlier tendency for the tax-GDP ratio to rise through additional taxation measures. But as noted earlier the government has proposed in its new direct tax 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.

Media reports suggest that there has been a concerted campaign against the tendency of the government to enhance its revenues by increasing resources garnered through taxes on profits and higher income group incomes. The direct tax code may turn out to be the means through which the government succumbs to that tendency.

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