Based on the numbers for the first two months of the current year, it is quite likely that direct taxes""essentially, corporate, personal income and capital gains taxes""will contribute over half of the government's total tax revenues this year. They were very close to garnering the majority share last year. Given that most forecasts for GDP growth this year lie in the 8-9 per cent range, growth in corporate profits and household incomes should sustain the trend. As this pattern consolidates, it takes the Indian tax system closer to the benchmarks of developed countries, which can be considered a significant achievement for a number of reasons. This is also an endorsement of the tax reforms of the past 15 years""more moderate tax rates on incomes have encouraged greater compliance, so that the ratio of direct tax revenue to the gross domestic product (GDP) has improved consistently, and indeed fairly dramatically. | |
| Direct taxes have three major advantages over their indirect counterparts""customs and excise duties and service taxes, in the Indian context. First, they are usually designed to be progressive. People with higher incomes pay proportionately more taxes. At an aggregate level, therefore, the proportion of tax revenues collected from the better-off taxpayers is greater. Second, they possess the characteristic of "automatic stabilisation"; if incomes fall because of a growth slowdown or recession in the economy, because of their progressive nature, the total burden of taxation on individual incomes falls. Consequently, disposable (after tax) income falls by less than GDP, buffering households against the recession to some extent. Third, they are completely neutral across different types of economic activity, whether by sector or at different stages of production. Taxes are collected regardless of where the income is generated""and hence they do not introduce distortions in the system, as indirect taxes can. |
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| Indirect taxes can be designed to achieve similar attributes, but the task is more difficult to achieve. For example, excise and customs duties are levied on goods regardless of who consumes them. Their impact on less well-off consumers is, therefore, greater. Tax rates can be differentiated based on selling prices, or on the nature of goods, in order to cut the burden on lower income households, but there are no guarantees against spillover, while administrative challenges mount. In short, while indirect taxes have their role to play, particularly in the form of a comprehensive goods and services tax, which the country aspires to achieve, a larger proportion of taxes being collected by direct means bodes well for both economic fairness and administrative efficiency. |
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| However, one should not lose sight of some of the negative drivers of the shift. Over the last few years, the rate of growth of excise duties, once the most significant source of revenue, has lagged far behind the growth in its base, i.e. growth in the value of industrial output. The main explanation for this is the many and varied exemptions that the system provides, based on scale of production, location, technology and other factors. These exemptions neutralise the self-enforcing feature of a value-added tax, because if a producer does not pay tax on his output, he has no incentive to deal with suppliers who pay taxes, for which he can claim credit. Had these issues been dealt with more effectively, it is quite likely that excise duties would be contributing more revenues than they currently do. |
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| Overall, the country can look at the decade since Mr. Chidambaram's "dream budget" of 2007 with a sense of satisfaction. Since that time, the tax system has become more diversified and achieved greater penetration. More activities and a larger proportion of people are contributing to the pool, allowing a reduction in the burden falling on the average individual. Now, if only the same improvements can be achieved in the public expenditure system! |
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