What does tax buoyancy indicate and how does it impact tax devolution?

Poor responsiveness of tax collection to economic growth poses new challenges for norms on sharing taxes with the states

The highest tax buoyancy rate for the Union government during the last 28 years after economic reforms was achieved in 2002-03. Tax buoyancy that year had risen to 2, which meant that the Centre’s gross tax revenues had grown at double the rate at which the Indian economy had grown in nominal terms. The finance minister under whose watch such a high level of tax buoyancy was recorded was Yashwant Sinha. 

Tax buoyancy is one of the key indicators to assess the efficiency of a government’s tax system. It measures the responsiveness of tax mobilisation to economic growth. Tax buoyancy depends largely on the size of the tax base, the friendliness of the tax administration and the reasonableness as well as simplicity of the tax rates. 

Yet, it is not fair to look at just one year’s tax buoyancy to arrive at any conclusion on the tax system’s efficiency or the responsiveness of tax mobilisation to economic growth. There are many factors at play in either boosting or pulling down tax buoyancy and there is also a lag effect of taxation policies that can be captured only by examining the trend over a longer period of time.

For instance, just a year before tax buoyancy hit the record high of 2, gross tax collections in 2001-02 actually declined even as the economy had clocked a nominal growth rate of just over eight per cent. Thus, tax buoyancy was in negative territory, the only time it has been so low in the post-reforms era. Quite interestingly, therefore, Sinha holds the record for both the highest and the lowest tax buoyancy rates in post-reforms India. In his five years as finance minister, he was troubled by poor tax buoyancy in two years, but was rewarded with commendable tax buoyancy rates in the other three. 

By that yardstick, Sinha’s performance is probably just a shade below that of  P Chidambaram when he was the finance minister in the Manmohan Singh government from 2004-05 to 2008-09. During the first four years of his tenure as finance minister in this period, Chidambaram managed to keep tax buoyancy between 1.3 and 1.7, a creditable performance. In the fifth year, that is, 2008-09 (Chidambaram, however, left the ministry in December 2008 after the Mumbai terror attack) there was a sharp fall in tax buoyancy to about 0.2. This was due to the impact of the global financial meltdown and the tax measures taken to alleviate its impact on the economy. 

While tax buoyancy in a year may reflect the impact of an adverse set of developments during that year, but usually the longer-term trend of tax buoyancy during a period of about five years results from policy changes made a few years earlier. The lag effect of policy changes on tax buoyancy can hardly be ignored. Thus, tax buoyancy between 1991-92 and 1997-98 was fairly moderate between 1 and 1.3 in four of these seven years and was poor in the remaining three years. But the tax reforms undertaken during this period did help boost the tax buoyancy rate in the following decade, even though there were occasional years when buoyancy would suffer due to some economic developments. 

Similarly, it can be argued that Sinha’s tax reforms, particularly in the indirect taxes regime, helped tax buoyancy in the Chidambaram years that followed immediately after Sinha’s tenure. The period of four years between 2009-10 and 2011-12, when Pranab Mukherjee returned to the finance ministry, saw tax buoyancy quite patchy and was below 1 in as many as two years and above 1 in the remaining two years. 

Arun Jaitley’s five years as finance minister also saw steady performance in tax buoyancy. In Jaitley’s first year in the finance ministry, tax buoyancy was below 1, but in the three subsequent years, tax buoyancy showed steady signs of improvement ranging between 1 and 1.6. However, in the last year that is, 2018-19, tax buoyancy declined to 0.7. And in the first half of 2019-20, when the Centre’s gross tax revenue grew by just 1.5 per cent over the same period of 2018-19, tax buoyancy fell further to about 0.15. This is on the assumption that the nominal economic growth in the first half is 10 per cent.  

Such deterioration in tax buoyancy is a cause of concern for the central exchequer. It can upset the government’s plans for fiscal consolidation and can provide a misleading basis for the 15th Finance Commission’s calculations on sharing the Centre’s tax revenues with the states. If the current low tax buoyancy is used to project the revenue growth for the next five years, revenue challenges for both the Centre and the states will only become more complicated.

The big question for the 15th Finance Commission is how it can arrive at a more reliable base for calculating tax buoyancy in the coming years. If it makes the wrong assessment now, the tax collection assumptions can become flawed adversely affecting the new tax devolution formula. Getting a sense of the long-term and sustainable trend of tax buoyancy will be crucial for the recommendations the 15th Finance Commission makes for tax sharing between the Centre and the states.