Here’s One Thing Modi Govt Should Do in Its Remaining Budgets

narendra_modi

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.

 

YearDirect taxes as a % of GDPIndirect taxes as a % of GDPTaxes as a % of GDP
2004-054.15.269.36
2005-064.475.49.87
2006-075.365.6210.98
2007-086.265.611.86
2008-095.934.7910.72
2009-105.833.769.59
2010-115.724.410.12
2011-125.594.4310.02
2012-135.594.7510.34
2013-145.634.3710
2014-155.634.319.94
2015-165.664.5810.24
Source: Reserve Bank of IndiaAverage10.25

 

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?

On that your guess is as good as mine!

The column was originally published in Vivek Kaul’s Diary on February 25, 2016

 

What Jaitley is doing to meet the Rs 1,05,000 crore tax collection gap

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010In the Mid Year Economic Analysis released in December 2014 it was estimated that the government will run short of the projected tax revenues by Rs 1,05,084 crore. As I have suggested in the past, this means that the government will have to slash its expenditure big time, in order to meet the fiscal deficit target of 4.1% of the GDP that it had set for itself when it presented the budget in July 2014.
deeper reading of a newsreport in The Economic Times suggests that this will now partly happen on its own. The government expenditure is essentially categorized into two categories-plan and non-plan. 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 planned 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.
Data released by the Controller General of Accounts(CGA) suggests that during the first nine months of the financial year the period between April and December 2014, the government spent Rs 3,52,631 crore or 61.3% of the Rs 5,75,000 crore plan expenditure that the government had budgeted for.
A government rule does not allow it to spend more than 33% of the plan expenditure in one quarter. At the same time the government cannot spend more than 15% of the plan expenditure in March. 

Given this, how do the numbers stack up? 33% of Rs 5,75,000 crore, the budgeted plan expenditure for the year, amounts to Rs 1,89,750 crore. The government has already spent Rs 3,52,631 crore between April and December 2014. Hence, for the current financial year as a whole, it cannot spend more than Rs 5,42,381 crore (Rs 3,52,631 crore plus Rs 1,89,750 crore).
This means that the government will automatically end up not spending Rs 32,619 crore. In fact, the 33%/15% rule applies at the ministry, department as well as scheme level. Given this, the actual number can be slightly different from the overall number arrived at.
What this means is that the government will have to further slash plan expenditure in order to meet the tax gap of Rs 1,05,084 crore. This shouldn’t come as a surprise given that in the last two financial years, this is exactly what the government did.
The plan expenditure target of the government during the last financial year was at Rs 5,55,322 crore. The actual plan expenditure came in at Rs 4,75,532 crore, which was close to Rs 80,000 crore or 14.4% lower. This is how the fiscal deficit of 4.6% of GDP was achieved.
A similar strategy was followed in 2012-2013 as well. In 2012-2013, Rs 5,21,025 crore was budgeted towards plan expenditure. The final expenditure came in 20.6% lower at Rs 4,13,625 crore.
The Economic Times suggests that the plan expenditure this time around will be Rs 80,000 crore lower. The paper goes on to suggest that this will be Santa’s late gift to finance minister Arun Jaitley.
This can hardly be the case given that plan expenditure is asset creating. In an environment where private investment continues to remain slow, if the government expenditure is also cut dramatically, it can’t be good for the economy. But given that the government’s revenue projections have gone dramatically wrong there is nothing much it can do other than slashing plan expenditure, given that non plan expenditure cannot be easily slashed.
The bigger problem here remains that India’s tax collections are very low in comparison to its gross domestic product. Analysts Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital in a recent report titled 
Modi’s ambitions will reshape India’s fiscal construct show that India’s tax collections are abysmally low as a proportion of its GDP. The next exhibit shows that clearly. 

Exhibit 1:India’s tax-to-GDP ratio remains
abysmally low at 11% as per FY15 Budget Estimates

Source: CEIC, Ambit Capital research, Note: Data is presented on financial year basis


At the same time, as the next exhibit shows, the tax to GDP ratio of India is lower than that of other emerging markets 

Exhibit 2: India’s tax GDP ratio is lower
than that of most emerging market peers

Source: World Bank, Ambit Capital research, Note: Data is presented on calendar year basis


Given this, it is very important that the government figure out ways of improving its tax collections. This is especially important in light of the fact that the government seems to have huge plans for spending money on improving India’s pathetic public infrastructure. 
As the Ambit Capital analysts point out: “India’s tax-to-GDP ratio has been range bound between 8% and 12% over the past two decades. Furthermore, a comparison with peers as well as with developed countries like the UK points to the vast tax revenue-generating potential in India which suffers from large-scale tax evasion.” 
The Ambit analysts also feel that boosting India’s tax-to-GDP ratio will be one of the major things that the Narendra Modi government will do over its term. As they point out: “Our discussions with well-placed policy experts suggest that enhancing India’s abysmally low tax-to-GDP ratio is likely to be one of the primary objectives that Modi will pursue over his five-year term.” 
One way of improving the tax-to-GDP ratio is to go about reducing the total amount of black money in the Indian financial system in a systematic way. While the government has made a lot of noise about bringing about all the black money that has left the Indian shores, it hasn’t had much to say about the black money floating around in India, which would be significantly easier to recover. Going after the black money in India would be the quickest way to significantly improve the country’s abysmally low tax-to-GDP ratio. 
The other major area that needs to be looked at are the tax rates and exemptions that come with them. As Swaminathan Aiyar pointed out in a recent column in The Times of India: “Currently , India has among the highest tax rates in Asia, but also hordes of exceptions.” 
Along with the budget every year, the government releases the revenue foregone number. This number for the last financial year 2013-2014 was estimated to be at Rs 5,72,923.3 crore. “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,” the statement of revenue foregone points out. 
In the table that follows it can be clearly seen that the Indian corporates benefit the most out of all the exemptions and deductions available under the various tax laws in this country. The businesses benefit the most with corporate income tax, excise duty and customs duty foregone, forming a bulk of the revenue foregone by the government. 

Tax

Year

(in Rs crore)

2012-2013

2013-2014

Corporate Income Tax

68,720.0

76,116.3

Personal Income Tax

33,535.7

40,414.0

Excise Duty

2,09,940.0

1,95,679.0

Customs Duty

2,54,039.0

2,60,714.0

566234.7

572923.3

Source: Annual budget


The revenue foregone number is based on certain assumptions. As the statement points out ” The estimates are based on a short-term impact analysis. They are developed assuming that the underlying tax base would not be affected by removal of such measures….The cost of each tax concession is determined separately, assuming that all other tax provisions remain unchanged. Many of the tax concessions do, however, interact with each other. Therefore, the interactive impact of tax incentives could turn out to be different from the revenue foregone calculated by adding up the estimates and projections for each provision.” 
Nevertheless, it is too big an amount to be ignored. In fact, the number is bigger than the projected fiscal deficit of Rs 5,31,177 crore for this financial year. Given this, the government needs to go through these exemptions carefully and figure out whether they are really needed. 
Of course, this exercise may not be possible to carry out before the budget, but it needs to be taken up seriously. Lower tax rates along with fewer deductions and exemptions should go a long way in improving India’s tax-to-GDP ratio.

(The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Feb 6, 2015)