Tough choice

Tough choice

The taxman is having a great time. His collections are growing much faster than the underlying economy. Is this enough reason for a tax cut?

By current trends, it seems almost certain that the tax department will cross the target set for it in the Union Budget, especially as far as income and corporation taxes go. So, it’s quite natural that the new data has brought with it a rising demand for tax cuts in the coming Budget. How sensible would that be?

The long-term case for lower marginal tax rates is quite clear. Lower taxes are an incentive to work, save and invest more. Economic growth rises as a result. And so do tax collections. In short, moderate levels of taxation paradoxically lead to higher tax collections.

But a lot depends on the immediate context as well. Two questions are important here. One, why are direct tax collections rising so fast? Two, does the current economic situation demand a tax cut?

Answer one: direct tax collections could be soaring because of better tax compliance or because the rich and companies are getting a growing share of national income. In other words, the cause could be either that fewer people and companies are evading taxes or that inequality is increasing.

Tax cuts make sense if they are rewards for honesty. But not if they are further sops for those who have benefited the most from the economic boom. The government will have to think through this politically sensitive issue before doing anything hasty in what could be an election year.

Answer two: while there is no doubt that India is in the early stages of a splendid long-term economic boom, there are growing macroeconomic risks to face in the short term. The trade deficit is growing. Capital inflows are swamping the economy. The global economy could be slowing down. Inflation in 2008 is likely to be higher than it was this year. All these call for?a?tight?fiscal?policy.?A?significant tax cut would be a good idea only if the government makes parallel cuts in spending. That seems unlikely to us.

The case for a tax cut is not as clear as it seems at first glance. The finance minister could make a few cuts here and there, perhaps in various surcharges, to signal to investors that there is scope for lower tax rates in the future. He should also focus on making the tax code more simple, so as to cut deadweight costs and reduce distortions in the allocation of capital and labour in the Indian economy. The productivity gains from this are likely to be substantial. (A flat tax of the type seen in certain East European economies is but a distant dream in India.)

And while the current call for lower taxes is not unreasonable, let us not forget how far ahead we have moved since the 1970s.

India’s tax regime has grown less suffocating over the past few decades. It is simpler and the rates of taxation are lower. Import tariffs are getting closer to regional levels, thus making the economy more competitive. The goods and services tax will reduce distortions and help create a single national market. The tax rates on individual income and corporate profits are also at far more sensible levels, right now. All this shows that the marauding state has stepped back a bit.


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