Tax structure: The one chart that underlines the importance of reforms
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Over the past few years, a spate of high-level corruption scandals has sharply dented the credibility of Indian capitalism. The rationale for economic reforms has also been called to question, given that India’s plutocrats and politicians seem to have captured a large share of the gains from reforms. In this environment of cynicism, it is easy to forget that corporations today contribute much more to the public exchequer than they did in the pre-liberalization era.
Indeed, it is precisely because of economic liberalization that India today has a far more robust and progressive tax structure than earlier. As the accompanying chart shows, the composition of India’s tax structure has changed dramatically since liberalization of the Indian economy in 1991.
The share of income taxes has also risen thanks to simplification of tax rules and better tax administration, but that story is well known. The sharper rise in corporate taxes is relatively under-emphasized. Instead, after each budget, we hear stories of revenues foregone thanks to writeoffs for corporations. Such stories are partial and ignore the profound transformation in India’s tax structure over the past two decades, fuelled by the rise in corporate taxes.
The surge in corporate taxes is directly linked to the freeing up of the economy, lowering of marginal tax rates, and the development of India’s capital market since 1991. Before 1991, high tax rates and the lack of a well-developed capital market meant that most corporations and their promoters had an incentive to under-report profits or net incomes. That changed after 1991, as more companies were listed on the bourses, and Indian stock markets emerged as a key source of funds for corporations. The market capitalization of all firms listed on BSE as a proportion of India’s gross domestic product (GDP) was a lowly 17% in 1991. The market-cap to GDP ratio crossed the 50% mark at the end of fiscal 2000, and reached 71% at the end of the last fiscal year.
Companies began vying with each other over the past two decades to declare higher profits to attract more investors, leading to better reporting of net incomes. The government was an indirect beneficiary of this process, as it saw its coffers swell because of higher tax revenues even as tax rates fell.
The Indian government’s ability to extract higher revenues from corporations is among the biggest success stories of the economic reforms, and one that has given the government the scope to fund ambitious social sector schemes.
It is important to recognize this success to appreciate the potential and the need for the next round of economic reforms.