The finance minister has set up a group to examine the pros and cons of an income tax amnesty to mop up black money. Based on a quick sketch of the economic theory of amnesties, evidence on the impact of past amnesties in India and elsewhere, and the current tax enforcement climate, there may be a case for declaring an amnesty now, provided other tax enforcement measures are taken in tandem.
Tax evasion and amnesty participation decisions can be viewed as being made after weighing costs and benefits in terms of a tax evader’s wealth or consumption. Among the rich or wealthy, however, consumption from saved taxes as a reason for tax evasion can be safely ignored. Instead, relative asset returns in the black and white sectors matter. The expected return on tax-evaded money invested in the black or informal sectors, adjusted for the probability of the evader getting caught by tax sleuths, constitutes the benefit from tax evasion. Alternatively, for those with money laundering opportunities, such as round-tripping of funds masquerading as foreign direct investment through a tax haven, the benefits are a return to legal investment, again adjusted for the risk of detection. The cost of tax evasion is the reduction in tax-paid white funds to invest in India’s booming legal economy. A tax amnesty can be viewed as a money laundering opportunity offered by the government.
So, the taxpayer will only participate in an amnesty if, compared to when she made the tax evasion decision, the amnesty offers a highly concessional tax rate on any black money she declares (case A), or if she feels that economic prospects have brightened (case B), or there is now a greater chance of black money being detected (case C). In the first case, the revenue gains from the amnesty are likely to be small besides favouring dishonest taxpayers. The revenue impact is worse if the taxpayer anticipates the amnesty and games the system by evading taxes and waiting for an amnesty. In the first two cases, an amnesty can also be viewed by taxpayers as a signal by the government of poor ability to detect evasion and black money. This will have an additional negative revenue impact.
In a statistical study (published in 1998) of the 12 income tax amnesties between 1965 and 1993, Dilip Mookherjee and I found that, as predicted by the theory outlined above, only the 1975-76 amnesty, which coincided with start of Indira Gandhi’s Emergency and tougher tax enforcement, yielded appreciable revenues. In fact, there was a negative direct and indirect revenue impact of the seven amnesties declared after 1980, which were likely to have been anticipated by taxpayers. Evidence from studies in other countries corroborate the negative revenue effect of intermittent amnesties. On the other hand, the impact of one-shot amnesties is context-dependent. One Indian amnesty with a possibly significant revenue yield was the 1997 Voluntary Declaration of Income Scheme (VDIS). This is likely due to the greatly enhanced post-liberalisation attractiveness of legal investment in India (case B above). Overall, while “business as usual” amnesties are a bad idea from the revenue and fairness perspectives, amnesties may be useful in special circumstances.
What special circumstances exist now? Enhanced international information-sharing between tax authorities and tougher bank disclosure rules on foreign accounts of Indians. This includes the recent amendments to India’s tax treaties with tax havens and countries with stringent tax secrecy laws, such as Switzerland. This increases the ability of Indian financial regulators to detect illegal money held abroad by Indians. So, an amnesty now may yield revenues directly and also indirectly by saving investigation and prosecution expenditure. Further, revenue gains from a successful amnesty will be immediate compared to the slow and uncertain outcome of enforcement through the court system.
Three other important issues need to be weighed before an amnesty is declared. First, why are India’s two (deplorable) permanent income tax amnesties not sufficient for those who now wish to confess their past sins and declare their black money? These two amnesties are via the Income Tax Settlement Commission which decides on tax dues for individuals who voluntarily disclose large unreported incomes, and the once-in-a-lifetime amnesty from prosecution under section 273(1) of the Income Tax Act. Is the reason overcrowding and uncertainty or, in the case of section 273(1), continuing large financial costs?
Second, how will the government credibly commit to tougher enforcement? To do this effectively the government will need to accelerate the process of international tax and financial reform. In particular renegotiation of, for example, the India-Mauritius tax treaty to reduce round-tripping is incomplete, Mauritius followed by Singapore being the leading sources of “foreign” direct investment in India. It may also consider setting up an International Tax Enforcement unit within the Income Tax Department. In tandem, it could consider removing section 273(1) and the equivalent section in the Direct Taxes Code (DTC) Bill. Further, the Settlement Commission could be refashioned as a forum to settle complicated tax cases as the Wanchoo Committee suggested in 1971.
The third issue, not dealt with here, is the amnesty facilitating foreign financing of terrorism and laundering of profits from activities like drug smuggling and prostitution.
On the design of the amnesty, arguments presented here suggest that a concessional tax rate is unnecessary and that the amnesty can succeed even if the amnesty tax rate is above 30 per cent. This will mitigate discrimination against honest taxpayers. Further, though the amnesty should target illegal foreign funds, it should also allow laundering of domestic black money.
Unfortunately, the finance ministry has tipped its hand prematurely by announcing that it is considering an amnesty. The amnesty will now be anticipated by black wealth holders. Incomplete reforms now or the anticipation effect later will reduce revenue from an amnesty whether it is declared immediately or after further international financial reform.
The writer is Senior Professor and Head, Centre for Economic Research, Goa Institute of Management
