Time to revamp the tax administration

It has been over two months since the government invalidated high-denomination currency notes, but the costs and benefits of the move are still being debated fiercely.

In terms of costs, high-frequency economic indicators such as auto sales and purchasing managers’ indices indicate that economic activity has been hit by the cash crunch. However, the data on tax collection suggests that the impact could be limited.

When it comes to benefits, assessing the real gains in terms of what was originally the currency reform’s primary goal—attacking the existing stock of black money stored in cash—will be a tricky process. And the burden of it will fall on a tax administration that is ill-equipped for it.

Success will depend on the value of old notes that have not returned to the system. Though the official data is not yet available, the numbers being quoted in the media suggest that most of the invalidated notes have come back into the banking system. But as Union finance minister Arun Jaitley, taking to Facebook over the weekend, noted, a large quantum of the invalidated currency being deposited in banks does not make it legitimate cash. It is possible that a large number of tax evaders have managed to launder their illicit wealth or are in the process of doing so—posing a big challenge to the system.

This situation—the fact that most of the invalidated notes have reportedly returned to the banking system and a large number of new notes are being recovered from various locations—suggests, obviously, that implementation of the currency swap was not as desired. It also exposes flaws in the existing system that make detection of black money difficult and underscores the scale of the problem that the administration has decided to deal with. It will be a huge challenge for the tax administration.

At the operational level, the tax department will now have to mine a vast volume of data to zero in on accounts that have been used to deposit unaccounted cash. This will not be easy as it will substantially increase the workload and can lead to litigation. Further, the department will have to handle the entire exercise with care and avoid causing discomfort to honest taxpayers. This will put enormous pressure on the existing capability and infrastructure of the tax department.

A recent Mint report noted that about 390,000 direct tax cases are pending across various forums and an internal committee has suggested that the department should reduce scrutiny to give more attention to litigation management.

Prime Minister Narendra Modi, in his address to the nation on New Year’s eve, said—this was also reiterated by the finance minister in his post—that only about 2.4 million people in the country declare income over Rs10 lakh. For the record, national income in the current year is estimated to be over Rs133 trillion. Large-scale tax evasion is one part of the problem; the other issue is that the system is not able to tackle it even close to effectively.

Without addressing this, any attempt to broaden the tax base will be akin to an attempt to fill a bucket with a hole. Thus, even as the government looks to bring more people into the tax net on the basis of the information generated in the last two months, it would do well to also work on a medium-term strategy to enhance the capability of the tax administration. Going forward, big data analytics will become increasingly important—using data generated by the consumption patterns of individuals to identify tax evasion, for instance. Concurrently, the tax department will need to be skilled adequately.

The government will simultaneously need to work on laws and regulations to reduce the generation of black money in the system. For instance, as has been noted by several experts, high stamp duty in real estate encourages under-reporting, which results in the creation of black money. Cleaning up political finance will reduce the generation of black money to a great extent. It will also give a strong signal to the public in general as to which way the wind is blowing. Further simplifying the tax structure and lowering tax rates would help boost compliance.

The Modi government has taken various steps, including the currency swap, to deal with black money. But if it is to build on any of the benefits that have accrued so far, it must make the structural changes to the tax administration needed to minimize the generation of black money and make detection of tax evasion an ongoing process.

Will improving the tax administration lead to higher tax revenue? Tell us at views@livemint.com