Earlier this week, the government released some interesting data on direct taxes which essentially are composed of corporate taxes, personal income tax. They also include tax collected through the income tax amnesty schemes launched by the governments over the years.
How have these taxes done over the years? Has the Narendra Modi government managed to collect more direct taxes than the earlier government’s (as is often said)? The recently released data provides the answers.
Take a look at Figure 1. It basically plots the direct taxes to the GDP ratio over the years.
What does Figure 1 tell us? It tells us very clearly that the direct taxes collection as a proportion of the GDP, has remained flat over the last few years, including the three years of the Modi government. It also tells us very clearly that whenever a politician talks about the collection of direct taxes (or for that matter any other tax) going up, it should be in the context of the size of the economy (i.e. the GDP).
If that is not the case, then he or she is clearly bluffing or does not understand how taxes are reported. As I said earlier, the direct taxes are comprised of personal income tax, corporate tax and other direct taxes. First and foremost, let’s take a look at how things look if we ignore the other direct taxes. This is important for the year 2016-2017, when the government managed to collect a significant amount of tax, through two income-tax amnesty schemes, one launched before demonetisation, and one after it.
Source: Author calculations based on data taken from http://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf
Unlike Figure 1, which curves up at the end, Figure 2 is more flattish, once we adjust for the other direct tax. This matters in a year like 2016-2017, when the government collected Rs 15,624 crore as other direct tax, much of which was collected from income tax amnesty schemes. Once adjusted for this, the direct taxes to GDP ratio in 2016-2017 falls to 5.49 percent. In 2015-2016, it was at 5.46 percent of the GDP. This is much lower than the 6.30 percent achieved in 2007-2008. Hence, the direct taxes to GDP ratio has fallen over the years.
It is important to take a look at how does the situation look for corporate tax and personal income tax, as a proportion of the GDP, the two most important constituents of direct taxes. Let’s take a look at Figure 3, which plots the corporate income tax as a proportion of GDP.
Source: Author calculations based on data taken from http://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf
Figure 3 tell us very clearly that corporate income tax to GDP ratio has been falling over the years. It has fallen from a peak of 3.88 percent of the GDP in 2007-2008 to 3.19 percent in 2016-2017. One reason for this has been the slow growth in corporate earnings over the last few years. Finance Minister Arun Jaitley has talked about lowering corporate income tax rates, but that hasn’t really happened. Whether lower taxes lead to higher collections remains to be seen.
Now let’s take a look at Figure 4, which plots to the personal income tax to GDP ratio.
Source: Author Calculations based on data taken from http://www.incometaxindia.gov.in/Documents/Direct%20Tax%20Data/Time-Series-Data-2016-17.pdf
Figure 4 makes for an interesting reading. While, personal income tax to GDP ratio like the corporate tax to GDP ratio also fell, it has managed to recover over the years. Basically, the loss of income tax from the corporates has been covered by getting individuals to pay more income tax, on the whole. One reason for this lies in the fact that the number of individual assessees have risen at a much faster rate over the years, than the number of corporate assessees. And this jump has basically ensured that the tax collections of the Narendra Modi government have continued to remain flat. They would have fallen otherwise.
On August 3, 2016, the Rajya Sabha, the upper house of Indian Parliament, finally passed the 122nd Constitutional Amendment Bill for the introduction of the Goods and Services Tax(GST).
The passing of the Bill will be looked at as an important achievement for the Modi government. Also, credit must be given to the Modi government for reaching out to the opposition and getting almost everyone on board (excluding the AIADMK party) to get the Bill passed in the Rajya Sabha.
To be honest, I didn’t think this would happen and which is what I had said in my past pieces. Nevertheless, the Bill could have been passed during the period 2009-2014, if the Bhartiya Janata Party, which is in power right now, hadn’t opposed it as vehemently as it did.
The television and the print media have gone totally gaga about the whole thing. If you were watching any television channel after the GST Bill was passed on August 3, you would think, looking at the excitement of the anchors, that the Indian per capita income had just crossed that of the United States.
The excitement of the mainstream media notwithstanding there is a lot that remains to be done for a Goods and Services Tax to become a reality. Here is what needs to happen on the legislative front:
a) The Constitutional Amendment Bill will first go back to the Lok Sabha in order to clear the amendments made to it in the Rajya Sabha. The Lok Sabha had earlier passed the Bill in May 2015. This should be fairly straightforward given that the Bhartiya Janata Party led National Democratic Alliance has the required numbers in the lower house of the Indian Parliament.
b) After this is done, 15 or more states will have to ratify the Constitutional Amendment Bill.
c) Then 29 states and two union territories will have to pass their own GST Bills.
d) The Parliament will have to pass the actual GST Act and the interstate GST Act, which will specific the structure of the tax and enable its collection.
As of now this seems doable given that the two Acts that need to be passed by the Parliament need a simple majority of more than 50 per cent and not two-thirds majority as was the case with the GST Constitutional Amendment Bill. Nevertheless, this will take time and when things take time, it is always possible that political parties change their mind.
Further, the GST Constitutional Amendment Bill will lead to the creation of the GST Council comprising of the finance minister of the union government, who will be its Chairperson, as well as the finance ministers of state governments. The GST Council will essentially go about setting the tax rates.
Before we go any further, it is important to understand what GST exactly is, and how will it help improve India’s taxation system.
What is GST?
India currently has many indirect taxes. Indirect tax is essentially a tax on goods as well as services and not income or profits, for that matter. India currently has a plethora of indirect taxes both at the state government level as well as the union government level. The GST will subsume many of these taxes. It hopes to have one indirect tax for the whole nation and this will convert the country into one unified common market.
The GST or value added tax(VAT), as it is known in other parts of the world, is already present in large parts of the world, as can be seen from the following chart.
How do things stand in India as of now?
Up until now, the Constitution empowers the Union government to levy an excise duty on manufacturing. Let’s take the case of a company which manufactures cars. It needs to pay an excise duty to the union government on every car that it manufactures. The current rate of excise duty is 12.5 per cent on small cars. While, the company pays this tax to the government, it ultimately recovers it from the end consumer who buys the car.
The union government can also levy a customs duty on exports as well as imports. Further, the constitution allows, the Union government to levy a service tax on the supply of services, which the state governments can’t.
On the other hand, the State governments are allowed to levy a value added tax(VAT) or a sales tax on the sale of goods. This division has essentially led to a multiplicity of taxes.
As the Report of the Select Committee of the Rajya Sabha on the 122nd Amendment Bill of the Indian Constitution presented in July 2015 points out: “This exclusive division of fiscal powers has led to a multiplicity of indirect taxes in the country. In addition, central sales tax (CST) is levied on inter-State sale of goods by the Central Government, but collected and retained by the exporting States. Further, many States levy an entry tax on the entry of goods in local areas.”
This multiplicity of taxes has led to an inherently complicated indirect tax structure. As the Select Committee Report points out: “Firstly, there is no uniformity of tax rates and structure across States. Secondly, there is cascading of taxes due to ‘tax on tax’. No credit of excise duty and service tax paid at the stage of manufacture is available to the traders while paying the State level sales tax or VAT, and vice-versa. Further, no credit of State taxes paid in one State can be availed in other States. Hence, the prices of goods and services get artificially inflated to the extent of this ‘tax on tax’.”
Let’s understand this through an example
Let’s take the case of a dealer in one state buying goods from another state worth Rs 1,00,000. As the goods are moving from one state to another, on this, he has to pay a central sales tax of Rs 2,000 (2 per cent of Rs 1,00,000). His effective purchase price works out to Rs 1,02,000. On this he builds a margin of Rs 8,000 and his sales price works out to Rs 1,10,000.
When he sells this good, the state sales tax (or the value added tax) will be charged on Rs 1,10,000. If the tax rate is 5 per cent, then it will work out to Rs 5,500 (5 per cent of Rs 1,10,000). This means that the final price of the good would be Rs 1,15,500 (Rs 1,10,000 + Rs 5,500).
In this case, the state sales tax is also being paid on the central sales tax of Rs 2,000 that has already been paid. Central sales tax paid while purchasing goods from one state is not available as an input tax credit while selling the goods in another state. This leads to a cascading effect as tax on tax needs to paid. In this case the cascading effect is Rs 100 (5 per cent of Rs 2,000 of central sale tax). This ultimately gets built into the price of goods, making them more expensive than they should be.
What are the practical implications of this?
The cascading effect and the fact that the indirect taxes already paid in one state cannot be deducted while paying indirect taxes in another state makes many Indian businesses uncompetitive. The Report on theRevenue Neutral Rate and Structure of Rates for the Goods and Services Tax (GST) (or better known as the Arvind Subramanian Committee Report) has an excellent example.
As the report points out: “Consider a simple example, where intermediate goods produced in Maharashtra go to Andhra Pradesh for production of a final good which in turn is sold in Tamil Nadu. Effectively, the goods will face an additional tax of 4 per cent, which will reduce the competitiveness of the goods produced in Andhra Pradesh compared with goods that can be imported directly to say Chennai from South and East Asian sources.”
This basically happens because goods move between states twice and a 2 per cent central sales tax has to be paid each time. As mentioned earlier, tax paid in one state cannot be deducted while paying more indirect taxes in another state. This essentially means that a programme like Make in India cannot take off in many cases.
What are the other implications?
Other than central sales tax, state governments levy entry taxes as well. These can be like octroi in order to fund a local municipal body or otherwise. These taxes are collected while goods are entering the state or a town. This explains to a large extent why trucks in India move as slowly as they do. This essentially drives up logistical costs.
As the Subramanian Committee report points out: “One study suggests that, for example, in one day, trucks in India drive just one-third of the distance of trucks in the US (280 kms vs 800 kms). This raises direct costs (wages to drivers, passed on to firms), indirect costs (firms keeping larger inventory), and location choices (locating closer to suppliers/customers instead of lowest-cost location in terms of wages, rent, etc.). Further, only about 40 per cent of the total travel time is spent driving, check points and other official stoppages take up almost one-quarter of total travel time. Eliminating check point delays could keep trucks moving almost 6 hours more per day, equivalent to additional 164 kms per day – pulling India above global average and to the level of Brazil. So, logistics costs (broadly defined, and including firms’ estimates of lost sales) are higher than the wage bill or the cost of power, and 3-4 times the international benchmarks.”This will be possible if GST becomes the order of the day. The entry taxes will be subsumed under GST. This will lead to a dismantling of check posts at state borders and there will be no need for trucks to be held up.
Around 72 per cent of Indian freight moves through roads. Hence, eliminating check posts will lead to a faster movement of goods through the length and breadth of the country. Crisil Research estimates that “eliminating delays at check posts will yield additional savings of 0.4-0.8% of sales [of companies].”
While, the state governments are yet to agree to removal of border check posts, as and when this happens, it will be one of the bigger benefits of the GST. If it doesn’t, it will make GST a little less useful.
What will GST do about all this?
The GST will subsume multiple indirect taxes. Take a look at the following table. It points out the indirect taxes which will come under GST and indirect taxes which won’t.
While GST plans to subsume many indirect taxes it does leave out several taxes as well. Hence, in that sense GST is not a one nation one tax that it is being made out to be.
How will GST work?
The GST will take the cascading effect of tax on taxes out of the equation. It will allow input tax credit for indirect taxes that have already been paid irrespective of what kind of indirect taxes have been paid and where they have been paid.
Take a look at the following table:
Basic Information/Kind of Tax
A. Transactions (exclusive of tax)
3. Value-added (A1-A2)
4. Tax on sales (10% of A1)
5. Tax on purchases (10% of A2)
6. Net tax liability (B4-B5)
7. Tax on retail sales (10% of A1/R)
Source: Professor Mukul Asher of the Lew Kuan Yew School of Public Policy, National University of Singapore
There are three levels in the above table- the manufacturer, the wholesaler and the retailer. Let’s start with the manufacturer who sells a product for Rs 600 to a wholesaler. He does not purchase any inputs and makes everything in house (I know this is an unrealistic assumption, but it just keeps the Maths a little simple).
On this, the manufacturer pays a tax at the rate of 10% which amounts to Rs 60. The wholesaler sells the product for Rs 800. On this he has to pay a tax at the rate of 10 per cent. This amounts to Rs 80, but he also gets credit for Rs 60 indirect tax which the manufacturer has already paid. Hence, his tax outflow amounts to Rs 20.
The retailer finally sells the product for Rs 1,200. On this he pays tax at the rate of 10%. This amounts to Rs 120. But he gets credit for Rs 80 (Rs 60 paid by the manufacturer and Rs 20 paid by the wholesaler). Hence, he actually pays a tax of Rs 40. In this way, there is no cascading effect and all the tax that has already been paid is taken into account.
What this also tells us is that GST is a destination based tax and will finally accrue to the government once the final customer has bought the good or the service. This explains why parties that rule states like Bihar and Uttar Pradesh have come out in its support. While these states may not have a large industrial base, they do have consumers.
How does all this help?
The GST has a self-policing feature built into it. As the Subramanian Committee report points out: “To claim input tax credit, each dealer has an incentive to request documentation from the dealer behind him in the value-added/tax chain. Provided, the chain is not broken through wide ranging exemptions, especially on intermediate goods, this self-policing feature can work very powerfully in the GST.”
As Crisil Research points out: “Since input tax credit will be available for all taxes paid earlier in the value chain, firms would require evidence of compliance from the preceding links to claim set-offs. Thus, they would prefer sourcing inputs from compliant firms. This could increasingly bring unorganised players under the tax net, thereby reducing their price competitiveness vs. organized players.” This will be one of the biggest benefits from the GST over the long-term as it will make the entire system more transparent.
This could also bring down the price competitiveness of unorganised players as they will have to go legitimate in order to keep their business going. This will increase their costs and could help the more organised players, who already have a strong information technology infrastructure in place. The following table shows the proportion of unorganised players sector wise.
But there might be some starting troubles on this front. The onus is on the customer to prove that all the suppliers in the value chain have paid their share of taxes, if he wants to take the input tax credit. This is as per Section 16(11)(c) of the Act. Basically what the section says is that if a supplier has not furnished proper returns or made the correct payment, then the customers of the supplier cannot avail of the input tax credit. And if it has been given, it will be reversed.
What will be the rate of tax?
This is something that the GST council headed by the finance minister needs to decide on. The Subramanian Committee has basically recommended four rates of taxes. A rate of 2 to 6 per cent for precious metals. A low rate on goods of 12 per cent. A standard rate on goods and services between 16.9 per cent to 18.9 per cent. And a high rate on goods at 40 per cent.
It is important that the GST council chooses a reasonable rate of tax. The unweighted OECD average rate for GST was 19.1 per cent in 2014 and 18.7 per cent in 2012. The recommendation of the Subramanian committee of a standard rate of 16.9 per cent to 18.9 per cent is in line with the OECD average.
Given the current rate of service tax is 15 per cent (including the cesses), a tax rate of 16.9-18.9 per cent is likely to make services expensive in the short run. This basically means that stuff on which you pay service tax (from your mobile phone bills to your credit card bills) is likely to become more expensive.
Crisil Research expects inflation as measured by the consumer price index is likely to go up by 60 basis points in the short-term. This will be in line with global evidence where inflation does go up in the short-term wherever good and services tax is actually implemented.
The trouble is that the rate of inflation is already looking up. Also, by the time GST becomes the order of the day, the next Lok Sabha elections will be around one to two years away. Will the government be willing to take on this risk? In the run up to the Lok Sabha elections the rate of inflation as measured by the consumer price index anyway goes up, as the government increases subsidy spends.
Why states like the idea of GST?
The state governments have come around to the idea of GST primarily because it allows them to tax services, which isn’t the case as of now. The GST being adopted has a dual structure with both the union government as well as the state governments levying a GST. Both the central GST and the state GST will be levied on every transaction of supply of goods and services, happening within a state. The taxes will not be levied on exempted goods and services.
As Crisil Research points out: “Multiple exemptions exist under the present tax system – the Centre has ~300 items exempted from central excise duty, while the States (together) have ~90 items exempted from VAT. These will be merged into a Final synchronized exemption list under the GST regime.”
It needs to be mentioned here that longer the list of exempted goods and services, higher the standard rate of GST will have to be. Given this, the government will have to limit exemptions if it wants a proper GST.
Other than central and state GST, there will be an interstate GST for transactions happening between states and it will be collected by the union government. The interstate GST will be roughly equal to the central GST plus the state GST. Input tax credit will be available on interstate GST. The following chart shows how the interstate GST will work.
What are the potential areas of conflict?
The former finance minister P Chidambaram of the Congress party has been talking about a standard GST rate of 18 per cent. The Kerala finance minister Thomas Isaac has remarked that capping the 18 per cent rate is too low. Other finance ministers have said the same thing.
A report in The Times of India suggests that Isaac has recommended a standard rate of 22-24 per cent, in order to ensure that states do not lose out on revenue. The situation as of now seems to suggest a standard rate of 20 per cent or more, will be arrived at.
To this Arvind Subramanian, chief economic adviser to the ministry finance said that a standard rate of “higher than 18-19% will stoke inflation”. This is primarily because the tax on services which is currently at 15 per cent will see a huge jump.
It remains to be seen what rate the GST council comprising of state finance ministers and the union finance minister come around to.
R Jagannathan writing for Firstpost makes this point in the context of small cars. An excise duty of 12.5 per cent is levied on small cars. Then there is the state level sales tax or value added tax of 12.5-14.5 per cent. The union budget this year added a one per cent infrastructure cess on cars. Over and above all this, some cities charge an octroi as well.
Hence, we are talking about an effective tax rate of around 28 per cent. If the standard rate of GST is 18-19 per cent then prices of small cars will come down. Crisil Research expects that the prices of small cars to come down by about 10 per cent.
But this is assuming that state finance ministers come around to the idea of 18 per cent standard rate of GST. As Jagannathan asks: “Why would any sensible finance minister at Centre or states reduce this to 18 percent?”This will continue to remain a tricky issue given that states need to subsume a whole host of taxes into the GST and are likely to demand (in fact they are already demanding) a standard rate of 20 per cent or more.
Also, there is the question of how will states compensate municipal corporations for taxes that are subsumed into the GST. Take the case of octroi. The Brihanmumbai Municipal Corporation makes a lot of money through octroi. If GST were to become the order of the day, the octroi will be subsumed into it.
As R Jagannathan writes in a column on Huffington Post India: “The Mumbai Municipal Corporation’s Octroi collections annually are in the range of Rs7,000-8,000 crore. Will GST collections in Maharashtra be enough to finance this revenue loss?” This is a question worth asking.
Further, the GST system as it has been envisaged will need a solid information technology backbone. This information technology system will essentially lead to a lot of lower level bureaucracy, which runs India’s indirect tax system, becoming useless. (Think of all those employees manning check posts on state borders for one).
While, the government does not fire employees, a move to GST will lead to the income from corruption for the lower level bureaucracy coming down. And this is unlikely to go down well with them. They, as always, remain in a position to create problems.
Also, in a recent interaction with a few economists, I was told that the state level bureaucracy remains unprepared for implementing the GST. The fact that GST is a destination based tax and not an origin based one, which is one of its core points, remains unclear to many of them.
The fiscal deficit conundrum
For the first five years, the union government will compensate the states for the loss of revenue arising because of GST. This is the known unknown that can really create a problem. If the compensation demands from states are more than what is expected, the fiscal deficit of the central government can shoot up. Fiscal deficit is the difference between what a government earns and what it spends.
In this scenario, achieving the fiscal deficit target that finance minister Arun Jaitley has set for the government will become difficult. In the budget speech made in February 2015, Jaitley had said that the government will achieve a fiscal deficit of 3.5% of GDP in 2016-17; and 3% of GDP in 2017-18. Running up a higher fiscal deficit will have its own set of repercussions.
What are the advantages of GST?
As we have already seen GST is basically a self-policing system and makes the entire system more transparent. The Subramanian Committee report points out that the GST “is a stark example of a tax believed to facilitate enforcement through a built-in incentive structure that generates a third party reported paper trail on transactions between firms, which makes it harder to hide the transaction from the government.”
This basically ensures that the tax collected by the government goes up. As analysts Saurabh Mukherjea, Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital point out: “Cross-country evidence suggests that the introduction of GST boosts the tax-to-GDP ratio by 1-2% points.” The analysts feel that GST will boost tax collection in India by bringing the unorganised sector which accounts for 59 per cent of India’s economy, under the purview of taxation.
While the rate of inflation is initially expected to go up, over the longer term, the inflation does come down as the cascading effect of indirect taxes is done away with and the cost of doing business comes down.
As the Ambit Cpital analysts point out: “Whilst the introduction of a single GST helped reduce inflation in New Zealand as well as Canada, inflation rose moderately in Australia and Thailand. However, the increase in inflation in Australia as well as Thailand was driven by unique factors such as domestic supply constraints. After adjusting for these factors, inflation in these two countries too was lower post GST implementation.”
And what about the GDP?
The finance minister Arun Jaitley has said in the past that GST is likely to push up the Indian GDP growth by 1 to 2 per cent. “This (GST) has the potential to push India’s GDP by one to two per cent,” Jaitley had said in April 2015. Jaitley’s statement was probably made on the basis of a December 2009 report brought out by National Council of Applied Economic Research(NCAER). In this report NCAER said that other things remaining the same the implementation of GST is likely to push up India’s GDP “somewhere within a range of 0.9-1.7%”.
The evidence on GST increasing GDP growth (or economic growth) is at best sketchy. As the Ambit Capital analysts point out: “Whilst it is difficult to assess the impact of GST on economic growth (as GDP growth is affected by a range of variables), cross-country evidence suggests that there is no clear evidence that the introduction of GST necessarily leads to higher GDP growth. Although the introduction of a single GST limits inefficiencies created by a heterogeneous taxation system, there is little evidence that it helps boost GDP growth rates.”
To conclude, there are many good things about the GST. Nevertheless, it is not a done deal yet and a few major issues remain, which will continue to test the Modi government in the days to come. Also, it is not the be all and end all, that the media is making it out to be. It is just one of the factors that will set India right in the years to come.
Sometime back the Income Tax department released some detailed data about the income tax returns filed during the assessment year 2012-2013. The income tax returns for the income earned during the financial year 2011-2012 were filed during the assessment year 2012-2013. The department released some other data points as well.
I had hoped I won’t write anymore columns around the data, but then that is not how things have turned out to be.
One of the interesting data points that I wrote extensively about was that in the assessment year 2012-2013, only around 2.88 crore individuals filed income tax returns. Of this number, around 1.62 crore did not pay any income tax. Only the remaining 1.26 crore individuals paid some amount of tax.
Of this number, around 1.11 crore paid a total amount of income tax upto Rs 1.5 lakh. The average income tax paid by these individuals was at around Rs 21,068. Of course, the median amount of income tax paid would be even lower.
The interesting thing is that even though the average income tax paid by these individuals was low, the total income tax paid, added up to a substantial Rs 23,446 crore. This was by far the highest amount paid by any category of taxpayers.
The next highest amount of tax was collected from individuals who paid income tax in the range of Rs 5.5 lakh to Rs 9.5 lakh. Around 1.79 lakh individuals fell in this category and paid a total income tax of Rs 12,580 crore. The average income tax paid worked out to around Rs 7.04 lakh. While at an average level this was substantially higher than the income tax paid by those paying tax of up to Rs 1.5 lakh, on the whole it was lower.
What does this mean? This essentially means that when it comes to income tax there is a fortune waiting for the government at the bottom of the pyramid. The term “fortune at the bottom of the pyramid” was coined by management guru CK Prahalad in a book of the same name.
In this book, Prahalad looked at the distribution of wealth and the capacity to generate incomes in the form of an economic pyramid. As he wrote: “At the top of the pyramid are the wealthy, with numerous opportunities for generating high levels of income. More than 4 billion people live at the bottom of the pyramid on less than $2 per day.”
Prahalad’s book was about these people and he felt that the “dominant assumption is that the poor have no purchasing power and, therefore, do not represent a viable market.” This he believed was incorrect and went on to show through various examples that even those earning less than $2 per day and can add up to substantial market size.
Along similar lines, those paying an income tax of less than Rs 1.5 lakh can also end up paying a substantial amount of income tax in total, though individually the income tax that they pay is low.
Hence, there is a lot of money that the government can collect at the lower end as income tax. This is a point that was made even in the most recent Economic Survey, released in February earlier this year. Take a look at the following chart.
What does this tell us? It shows very clearly that the basic tax exemption limit, only above which an income tax has to be paid, has risen at a much faster rate than the per capita income in India. As the Survey points out: “We can calculate in some sense the “missing taxpayers” in India—not those who are evading taxes altogether or under-reporting taxes but those who have legitimately gone under the tax radar due to “generous” government policy.”
What does this calculation tell us? Or to put it simply who are these missing taxpayers? These are those taxpayers who got left out because the basic exemption limit beyond which an income tax has to be paid has been raised from the level of Rs 1.5 lakh in 2008-2009. It currently stands at Rs 2.5 lakh.
If this threshold had not been raised as rapidly as it was, the government’s income tax collections would have gone up tremendously.
As the Economic Survey points out: “We ask how many taxpayers there would have been in 2012-13 if the threshold had been maintained at Rs. 1,50,000 (the threshold limit in 2008-09). We find that there would have been an additional 1.65 crore units incorporated within the taxation system (an addition of about 39.5 percent) and tax revenues would have been about R31,500 crores greater. India’s tax-GDP would have increased by 0.32 per cent just by not having raised the threshold so generously.”
In fact, the Survey also points out that there is a lot that India can learn from China on this front. As it points out: “[The] Chinese success in bringing more citizens into the individual income tax net owes to setting a reasonable threshold for paying taxes and not changing it unduly. In contrast, in India, exemption thresholds for income taxes have been consistently raised. In fact, as Figure 7 [the chart shared above] shows, thresholds have been raised much more rapidly than underlying income growth so that today, the wedge between average income and the threshold has widened.”
The finance ministers who increased the tax exemption limit knew what they were doing. They were basically playing to the gallery. But the loss of taxes on this front was more than made up for through first through a higher service tax rate and now through various cesses like Swacch Bharat Cess and Krishi Kalyan Cess.
Of course, indirect taxes are in the end paid by everybody, even those who are not a part of the formal sector. In that sense, it was only fair on those paying income tax.
It is worth remembering that in economics there are no free lunches. If the government gives from one hand it takes away from another.
The annual budget of the Narendra Modi government will be presented by the finance minister Arun Jaitley on February 29, the last day of this month.
Given this, it is a season where everyone has been advising Jaitley on how to go about the entire thing. Some economists have said that the government should increase the public investment, in order to get the economy growing at a faster pace. Others have said that it is important that the government maintain the fiscal deficit target that it has set for itself and not spend more in the process of increasing public investment. Fiscal deficit is the difference between what a government earns and what it spends.
Regular readers of the Diary will know that I am in the government trying to maintain its fiscal deficit camp. Having said that I am not against the government ramping up public investment as long as it can find the money to do so without increasing the fiscal deficit and borrowing more in the process.
As World Bank chief economist Kaushik Basu writes in his new book An Economist in the Real World—The Art of Policymaking in India: “A fiscal stimulus is like an antibiotic. It is very effective when used for a short period of time. But if used repeatedly and over long stretches of time, the side effects tend to outstrip the benefits. In India’s case a large deficit is likely to fuel the inflation rate.”
Given this, it is very important as to how the government goes about increasing public investment. As Basu writes: “Choices have to be made very carefully. The first task to which more effort needs to be directed is raising tax revenue.”
Take a look at the accompanying table. Between 2010-11 and this financial year, the taxes as a proportion of gross domestic product have more or less been similar, and have varied within a narrow range. Interestingly, the taxes as a proportion of GDP have fallen since 2007-08.
Direct taxes as a % of GDP
Indirect taxes as a % of GDP
Taxes as a % of GDP
Source: Reserve Bank of India
One possible explanation for this lies in the fact that both the stock market as well as real estate prices rallied between 2002-03 and 2007-08. This meant that investors would have made a lot of capital gains, on which they would have paid capital gains tax. This would have pushed the total amount of income tax collected by the government.
In 2001-02, the direct taxes amounted to around 2.94% of the GDP. By 2007-08, they had jumped up to 6.26% of the GDP. Another possible explanation for this lies in the fact that the salaried class got very good increments during the period. Also, the wealth effect was at play as well. With stock prices and real estate prices going up, people felt wealthy and in the process indulged in greater consumption. This led to the collection of higher indirect taxes. The collection of indirect taxes fell dramatically after 2007-08. In 2009-10, indirect taxes collected were at 3.76% of the GDP.
Since 2010-11, the collection of direct as well as indirect taxes as a proportion of GDP has been more or less flat. What this means is that the same set of people are essentially financing the Indian government and there seems to have been no effort made to expand the tax base. As Basu puts it: “Not only is India’s tax-to-GDP ratio low, it went down over the last seven years. Global comparison suggests that India can do much better.”
How does India fair in comparison to other countries when it comes to the tax to GDP ratio? A study titled Tax Revenue Mobilisation In Developing Countries: Issues and Challenges points out: “In comparative perspective, developing countries raise substantially less revenue than advanced economies. The ratio of tax to GDP in low-income countries is between 10% and 20% whereas for OECD economies [or developed economies] it is in the range of 30- 40%.”
What this clearly tells us is that India is at the lower end of the spectrum when it comes to collecting taxes and hence, there is tremendous scope to improve. As Basu puts it: “India should aim to reach a tax revenue-to-GDP ratio of 15 percent within two or three years, and then set an even higher target of, for instance, 20 percent over the medium term.”
This does not mean that the government has to raise tax rates. As Basu writes: “This can be done almost entirely through plugging of loopholes and prevention of tax evasion, and the implementation of a more rational tax code, without having to raise taxes.”
Interestingly, along with the budget every year, the government releases the statement of revenue foregone. As the statement released with the last budget pointed out: “The aggregate revenue impact of incentives available in respect of direct and indirect taxes (levied by the Central Government) is Rs 5,49,984.1 crore for 2013-14 and is projected to be Rs 5,89,285.2 crore for 2014-15.” The point being if the tax laws did not have a significant number of exemptions, the government would have collected more tax.
As the statement further points out: “The estimates and projections are intended to indicate the potential revenue gain that would be realised by removing exemptions, deductions, weighted deductions and similar measures.”
Hence, there is a lot to gain for the government if it goes about plugging these loopholes. But then that would mean side-lining corporate lobbies and big business, which finance political parties. Can the Modi government afford to do that?
The annual report of the ministry of finance points out that the total number of income tax assessees as on October 30, 2014, had stood at 4.79 crore. The number had stood at 4.7 crore as on March 31, 2014. As on March 31, 2011, the number had stood at 4.08 crore. This means that between March 2011 and March 2014, the number of assessees filing their income tax returns went up by a minuscule 4.8 per year. In fact, the method of measuring the total number of income tax assessees was revised in March 2014 and this revision has pushed up the number of assessees considerably. As per the earlier method, the total number of assessees as on March 31, 2011, had stood at 3.55 crore. The new method pushed up the total number of assessees by more than 50 lakh, as of end March 2011. This is not a reason to worry given that the new methodology is more reliable and accurate. Nevertheless, despite this revision, on the whole, the total number of income tax assessees in India remains very small. In comparison, nearly 45% of American population files income tax return. What this means in an Indian context is that India has a huge informal economy which as Taimur Baig of Deutsche Bank Research puts in a recent research note, operates “outside the lens of formal observation, oversight, or analysis.” “India’s statistics commission suggests that half the gross national product is accounted for by the informal economy…Numerous businesses are unincorporated, transactions involving huge quantities proceed daily on a cash basis, most people and businesses do not file for taxes, making a sizeable chunk of the economy unregulated and unsupervised…The government finds it hard to widen the tax net, ending up overburdening the formal sector,” writes Baig. The government’s inability to widen the tax net as Baig writes and as data in the annual report of the ministry of finance suggests, has led to a situation where the government has to regularly slash expenditure towards the last few months of the financial year. Take the case of the last financial year 2014-2015, the total expenditure of the government when the budget was presented in July 2014 had stood at Rs 17,94,892 crore. By the time the next budget was presented in February 2015, the total expenditure had been slashed by 6.3% to Rs 16,81,158 crore. This is a trend that has played out in each of the last three financial years. Typically when the government has to cut down on its expenditure, it is the plan expenditure which faces the severest cut. Take the case in 2014-2015, the plan expenditure at the beginning of the year had been set at Rs 4,53,503 crore. It finally came in at 19.1% lower or Rs 3,66,884 crore As I have often pointed out in the past, plan expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government. Non-plan expenditure on the other hand is an outcome of plan expenditure. For example, the government constructs a highway using money categorised as a plan expenditure. But the money that goes towards the maintenance of that highway is non-plan expenditure. Interest payments on debt, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure. Given the regularity of the non-plan expenditure the asset creating plan-expenditure gets slashed. And that is clearly not a good thing. This largely happens due the inability of the government to grow its tax base. Another disturbing trend that has emerged over the last few years is the growing dependence of the government on revenues from indirect taxes like customs duty, excise duty and service tax. Data from the Reserve Bank of India shows that in 1990-1991, direct taxes (income tax, corporation tax and wealth tax, which has been done away with from this financial year) formed 16.06% of the total taxes collected by the government. Indirect taxes formed 83.94%. In 1991-1992, the year economic reforms were first initiated, direct taxes jumped to 20.2% whereas indirect taxes fell to 79.8%. Since then, direct taxes maintained their upward move and by 2009-2010 formed 59.5% of the total taxes. The share of indirect taxes had fallen to 40.5%. The trend has been reversed since then and in 2013-2014, the share of direct taxes had fallen to 53.9%, whereas indirect taxes had jumped to 46.1%. This is a clearly worrying trend simply because indirect taxes are regressive. A regressive tax is essentially a tax which is applied uniformly on everyone and given that it means that individuals with lower-incomes are hit harder. That isn’t the case with direct taxes like income tax where the marginal rate of taxation goes up as the taxable income goes up. Given this, it is important that the government focuses on increasing the total number of people paying direct taxes. As Baig of Deutsche Bank Research points out: “Tax authorities in recent decades have handed out simplified procedures to file for taxes and register businesses, although the results have not been encouraging. Previously untaxed parts of the economy, especially in the services sector, have been brought into the tax net, but the fact that tax yield has not improved suggests room for improvement.” Also, the government seems to be focussed on recovering the black money that has already been accumulated. Some focus on widening the tax base and ensuring that the black money that will be generated in the future comes down will not do it any harm.