Lower tax rates continue to deliver higher tax collections as more Indians voluntarily pay their dues, according to officials in the finance ministry.
Personal income-tax (I-T) collections this fiscal have risen despite a reduction in effective tax rates, contrary to forecasts made by the finance ministry in the 2010 Union Budget. “Voluntary compliance is the reason” for the increase in personal tax collections, a senior finance ministry official said on condition of anonymity.
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According to another ministry official, I-T collection trends have a lesson: lower the tax rates and reap the benefits of better compliance.
Finance minister Pranab Mukherjee seems to believe in the benefits of an inverse relationship between tax collections and tax rates.
“Taxpayers have responded positively to these concessions by contributing a higher level of taxes (to earlier reductions),” Mukherjee said while presenting the February 2010 budget. “There is a persuasive case for further relief by broadening the tax slabs.”
The finance ministry bureaucracy chose to play it carefully. Soon after Mukherjee’s speech, additional information released by the ministry estimated that the reduction in effective rates of personal I-T would lead to a contraction of Rs 26,000 crore in tax revenue compared with the previous year.
Now, after nine months, personal I-T collections between April and December increased year-on-year by 11% to Rs 87,178 crore (including residual fringe benefit tax paid this fiscal). All indications show the final collections in the current fiscal would stick to the early trend, the second finance ministry official said.
The ministry’s belief on the inverse relationship between tax rates and collections echoes the controversial Laffer Curve.
The term, which was coined after economist Arthur Laffer, indicates that at some point of the economy’s evolution, the reduction in marginal rates of tax would lead to an increase in the tax base, and eventually to a rise in tax revenue, or collections. Graphically, it is depicted by an inverted “U” shape, indicating revenue would at some stage increase with a drop in rates.
The ministry’s belief in the relationship between tax rates and tax collections has met with scepticism from some economists.
The common thread running through their view is that in the current fiscal, the increase in personal tax collections is being primarily driven by the large nominal economic growth in the wake of high inflation.
In the last budget’s forecasts, the Union government announced a nominal gross domestic product growth (GDP) of 12.5% in 2010-11 as inflation for the year was expected to be 4%. In the first half (April-September), nominal GDP grew 19.8%.
“I would put most of the revenue growth due to nominal growth effect,” D.K. Srivastava, director of Madras School of Economics and a member of the 12th Finance Commission, said. “That would be the most important reason.”
Srivastava said he was unaware of any rigorous study in the recent past on the likelihood of the Laffer Curve effect in India. “Compliance and perceived high marginal rate are difficult to quantify,” he said.
The ministry’s belief is supported by the assumption that behaviour improves with a reduction in tax rates, or the so-called voluntary compliance.
According to Jayati Ghosh, economics professor at Jawaharlal Nehru University, a tax assessee’s behaviour is more likely to be driven by the efficacy of enforcement.
“Both individuals and corporates assess the extent to which they can get away,” Ghosh, said.
“Enforcement has improved since the UPA-I (United Progressive Alliance),” she added, explaining that measures such as the tax department independently accessing information such as credit card spends improved compliance.
According to N.R. Bhanumurthy, economist at National Institute of Public Finance Policy, though the current fiscal’s tax collections have largely been driven by the unexpected nominal GDP growth, the Laffer Curve impact could not be entirely written off.
“In my view, there could be some presence of Laffer Curve kind of behaviour,” Bhanumurhty, said. “We might be in the second half of the Laffer Curve, although it is an empirical question.”
The rise in nominal incomes over the last few years has added to the challenge of studying the presence of Laffer Curve in the economy.
“It’s difficult to work out a suitable parameter of Laffer Curve without elaborate distribution of income,” Srivastava said.
“Tax slabs are not adjusted to reflect the bulge towards the middle-income group,” he added, explaining an income range between Rs 10 lakh and Rs 1 crore could be termed middle income.