Parthasarathi Shome: India's effective tax ratio

The tax effort of a country is important since, ideally, only revenue collected should be spent on government expenditure whether current or capital expenditure. Tax effort is generally measured by the tax-GDP ratio. The “buoyancy” of a tax reflects its revenue generating capacity. The income tax is “buoyant” since it tends to be “progressive”, that is, its rates escalate with income. Thus, when the economy is booming, so do incomes — and tax revenue rises more than proportionately compared to income. Of course, no intelligent government would legislate very high progressivity since that leads to tax evasion or reduced work effort. By contrast, taxes that have fixed rates suffer from a lack of buoyancy — though, if rates are set in ad valorem or percentage terms, rather than in “specific” or nominal terms, then revenue yield from such taxes would rise with inflation, if not as fast as if the rates were progressive. Such taxes are typically levied on domestic production such as excises, and on consumption such as value-added tax (VAT) or the goods and services tax (GST), as well as on imports in the form of customs duty.

Production taxes are easy to collect at the factory gate as is customs duty at importation points. Income taxes on individuals, corporations, firms, or capital gains, or taxes on wealth and gifts are not so easy to collect. First, collection points for production and imports are far fewer than points of income generation; so a nascent tax administration in the early stages of economic development has higher success rates collecting commodity taxes than income taxes. Consequently, the economy contends with lower revenue buoyancy until the tax administration is able to significantly expand the base of income taxpayers.

In India, the central government’s tax/GDP ratio is around 10 per cent, with slightly higher collection from commodity taxes (5+ per cent) than income taxes (5- per cent). Interestingly, during 2004-08, a golden age period for tax revenue growth in real terms – having crossed 20 per cent per annum in 2007-08 – income tax collection surpassed commodity taxes. Major tax administration and tax structure reforms at the central level occurred, including the use of third-party information on major transactions of taxpayers, enhanced computerised processing of tax returns, and scaling back the income tax’s rates while broadening its base — thus garnering a Laffer-type positive revenue effect. Revenue gains were achieved despite the lowering of excise and customs duty rates, as a policy measure to reduce distortions in resource allocation caused by production taxes. However, the revenue gains were reversed subsequently during the global economic crisis with the central tax/GDP ratio declining considerably by about one per cent of GDP.

Adding states’ tax revenue to the Centre’s raises the 2005 tax/GDP to 16.5 per cent. It rose to almost 19 per cent in 2007 but fell back to 18 per cent during the global economic recession. Thus, it was not sustained. At the states’ level, the revenue growth was achieved by introducing the VAT which was more broadly based than the earlier sales tax, as well as through administrative gains realised from the VAT’s debit minus credit principle that facilitates a self-checking mechanism against tax evasion. This kind of tax revenue growth as experienced in India is no small feat for a developing emerging economy with all its constraints in generating revenue.

In international circles, a common theme is India’s low tax effort. Is this true? We must consider India’s subsistence population who cannot be taxed. Ideally, therefore, subsistence incomes should be removed from GDP when calculating tax/GDP. Doing that would yield the correct “effective” tax effort. A cross-country search revealed, however, that subsistence income data are difficult to obtain. A second best was to obtain poverty level income which, of course, is lower than subsistence income. Even if we use only the poverty-based concept – that is, non-poverty GDP (NPGDP) as in the Table – India’s effective tax/GDP ratio rises by more than three per cent, to almost 20 per cent from 16.5 per cent in 2005. Extrapolation would result in an effective tax/GDP ratio of approximately 22 per cent in 2007 and 21 per cent in 2009.

This exercise was carried out also for selected other countries where meaningful comparable data were available. The tax revenue data are from IMF Government Financial Statistics. They include cash and non-cash tax revenue and social contributions to central, state and local governments in units of local currency. The current GDP data are from the World Bank Databank in local currency. The poor population has been computed using the percentage of poverty headcount in total population at a $1.25 per day poverty line. Income of the poor is the product of the size of the poor population and their per annum income in local currency using the $1.25 poverty line. NPGDP is the difference between GDP, and GDP of the poor.

Because India is poorer than the compared countries, using NPGDP implies a higher increase in effective tax/GDP for India. For Chile and Sweden, using NPGDP versus GDP makes little difference. For Brazil, it makes a small difference, and for China, slightly larger. For India, the difference is substantial. The difference would be larger with non-subsistence GDP. It is thus important not to blindly make cross-country comparisons of tax/GDP without recognising poor or subsistence populations. Indeed, India’s effective tax/GDP is not as low as is usually made out to be when one considers from whom tax revenue can be realistically collected. This of course does not imply that the taxpayer population cannot be expanded since many under-report and some do not file tax returns, thereby failing to contribute their due share to the exchequer.

The writer is a professor at Icrier, New Delhi
These opinions are his own
Neetika Kaushal assisted with the Table
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