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Sanjeev Sanyal: A time for radical tax reform

A banking transaction tax may not work, but it has triggered a much-needed debate over tax reform

Sanjeev Sanyal 

Sanjeev Sanyal

A few weeks ago, a Pune-based think tank, ArthaKranti, put forward a proposal to abolish virtually all taxes and replace them with a simple banking transaction tax (BTT). The idea soon had the world of Indian economists abuzz. Not only is the BTT a radical suggestion, but it became known that the Bharatiya Janata Party was studying it and might consider including it in its manifesto. Whatever one may think of the specific proposal, it must be accepted that ArthaKranti has forced a much-needed national debate about India's inefficient and complex tax system.

So what is the fuss about? The proposal is that virtually all direct and indirect taxes (including income tax, sales tax, etc) would be abolished with the exception of customs duties. Instead, a flat two per cent tax would be levied on all transactions passing through the banking system. In order to ensure that economic agents do not bypass the tax by simply using cash, the proposal states that no transaction above Rs 2,000 would be legally valid (in other words, one could neither issue a legally valid invoice above this threshold nor legally enforce the transaction).

The proceeds from the two per cent transaction tax would then be shared out as 0.7 per cent for the central government, 0.6 per cent for the state government, and 0.35 per cent for local government. The remainder, 0.35 per cent, would be given to the banking system to pay for running the scheme.

For those who feel suffocated by India's byzantine tax system, this sounds like a breath of fresh air. However, there are many people, including most mainstream economists, who feel that it is a simplistic and untested proposal that is bound to fail. In my view, it must first be recognised that the plan is really made up of two components that are related but separate.

The first component of the proposal is to move the economy away from a cash-based system to one that is forced to function within the formal financial system. In a country where the use of cash is linked to the black economy, corruption and tax evasion, this is a good thing in its own right. Shifting everyone to an electronic payments platform is technologically simple - even the ubiquitous mobile phone can be harnessed for this purpose. So, if it is politically and administratively possible to move the whole economy to a largely cashless platform, it should be done irrespective of the transaction tax.

The second component is the BTT. As pointed out by many other economists, it is problematic at many levels ranging from fiscal federalism and equity to the impact of cascading on prices. All these objections are valid but, in my view, there is an additional fatal flaw. The proposal does not account for the way corporations, individuals and other economic agents would change their behaviour in a BTT world. For instance, businesses would change their supply chains such that they internalise many activities rather than outsource them to external vendors. This would reduce the number of financial transactions. Not only would this hurt tax revenue collections, but it would also mean that Indian businesses would be incentivised to create integrated Fordist production systems of the last century, rather than partake in the efficiencies of disaggregated networks that characterise the 21st century.

Very soon one would witness a plethora of other ways of gaming the BTT system. Large conglomerates would, for example, simply use internal book entries with group companies wherein only the net amount would be settled annually as a bank transaction. Individuals and small businesses could easily use barter or even split transactions to keep them below the threshold. No amount of spread-sheet modelling can predict the unintended consequences of all these behavioural changes. Eventually, the government would have to introduce modifications that, even if they worked, would soon make the BTT as complicated as the old system.

The point is that the BTT is not as simple as it looks and carries many risks. Even its supporters will accept that it is unworkable without first shifting the economy to a cashless platform. Given that a reduction in cash transactions is a good thing in its own right, why not attempt this first? It would benefit tax collections even without the BTT.

The problems with the BTT proposal, however, should not distract attention from the larger issue: that India needs to think about fundamental changes in its tax structure. The current system is not only hopelessly poor at collecting revenues, its absurd complexity weighs down the economy and penalises law-abiding citizens. Thus, we have the absurd situation where a tiny group of 400,000 people (those with annual income of more than Rs 20 lakh, or one per cent of taxpayers) contributed 63 per cent of income tax collections in FY2012. Delhi and the National Capital Region alone should be able to match this number. Meanwhile, large numbers of middle-class salaried folk are getting harassed for tiny sums.

A direct taxes code is currently in the pipeline, but it is simply not radical enough. Thus, I am glad that a previously little-known think tank has ignited this debate and is forcing policymakers and politicians to think big. Just as an illustration, consider the following personal income tax framework: an initial standard deduction of Rs 8 lakh, then 10 per cent up to Rs 18 lakh and then 20 per cent on incomes above this level. Most crucially, there should be no exemptions. Other taxes can be similarly rationalised. Such an architecture would not only be fairer to the law-abiding, but its simplicity would dramatically improve enforcement and reduce economic friction.

The writer is Deutsche Bank's global strategist.

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First Published: Tue, January 28 2014. 21:50 IST