India is an outlier in its tax policy6 min read . Updated: 22 Feb 2016, 10:57 PM IST
As India broke from its clichd Hindu rate of growth post 1991, its tax-to-GDP ratio stayed constant, belying those who predicted a spike
The celebrated French economist Thomas Piketty’s recent visit to India caused much consternation for his remarks. He proclaimed that 1) inequality in India is widening, 2) India’s tax-to-gross domestic product (GDP) ratio is abysmally low and 3) the Indian state spends too little on health and education. This sounded like cacophony or harmony to India’s commenting class, depending on one’s ideological fancies. Regardless of one’s views on India’s inequality, it is irrefutable from empirical evidence that India has a “twin deficit" issue in its taxation policy. That is, India taxes its citizens much lower in proportion to its GDP vis-à-vis other comparator economies and a substantive portion of such taxes are collected through largely regressive and distorting indirect rather than direct means.
Analysis of data from Organization for Economic Cooperation and Development (OECD) and India’s ministry of finance, spanning nearly 50 years from 1965 to 2013 across 35 countries, reveals that India is indeed an outlier. India’s tax-to-GDP ratio increased from 10.4% in 1965 to 17.2% in 2013. This includes both central and state tax revenues. The corresponding tax-to-GDP ratio for OECD countries (weighted by GDP) increased from 21% in 1965 to 33% in 2013. Purely in terms of a tax-to-GDP ratio, India has always been substantially lower than the average of OECD economies, over a 50-year period. Compared to a subset of OECD nations with lower GDP (Korea, Turkey, Mexico, Chile, Portugal, Greece, Slovenia, Indonesia and Poland), India’s tax-to-GDP is still lower at 17% versus an average of 24% for these nations. Piketty is certainly right in pointing out that India’s overall tax revenues are very small for the size of its economy. Then, is there a desired tax-to-GDP ratio that India should aspire for? Economic theory is, perhaps surprisingly, silent on what might be an optimal tax-to-GDP ratio. Conventional macroeconomics does say that it is not optimal for the tax rate to exhibit erratic jumps up or down—this is Robert Barro’s famous “tax smoothing" proposition, but this does not pin down any optimum. We also know that there is a maximum feasible tax-to-GDP ratio, which corresponds to the peak of the celebrated “Laffer curve", but this is only an upper bound on the government’s taxing capacity, again not a statement of what is the optimum. In the ultimate analysis, the optimum tax-to-GDP ratio is simply the lowest tax-to-GDP ratio which pays the government’s bills and keeps its books balanced, in the long run, without running perpetual budget deficits or surpluses. Thus, in the absence of a theoretical framework for an optimal tax-to-GDP ratio, it might be prudent for India to target a comparable tax-to-GDP ratio of other similar economies.
Some postulate that an economy’s tax-to-GDP ratio is, or should be, a function of its per capita GDP, and hence it is misleading to compare India’s with those much wealthier. The theoretical basis for such an assertion is debatable, and empirical evidence for this is also lacking. While India’s own tax-to-GDP has increased over 50 years with increasing per capita GDP, superficially supporting the theory, this fact hides more than it reveals, if one breaks the time period of study into two quarter-century periods. In the 25-year period from 1965 to 1990, India’s tax-to-GDP increased steadily from 10% to 16% while GDP increased 2.8-fold. In the subsequent 25-year period from 1991 to 2014, India’s tax-to-GDP stayed roughly constant between 16% and 17% while GDP increased 4.5-fold. It is puzzling to us that just as India broke away from its clichéd Hindu rate of growth post the 1991 economic reforms to grow much more rapidly, its tax-to-GDP ratio stayed constant, belying those who would have predicted an increase. That, curiously, India’s rate of tax revenues did not grow commensurate with its GDP growth post the 1991 reforms is inexplicable.
The second and perhaps the more important deviation in India’s tax structure from other major economies is in terms of the split of the total tax take between direct and indirect taxes. Direct taxes are taxes on income, wealth, property and capital gains. Indirect taxes are taxes on goods, services and excise taxes. Indirect taxes are considered regressive since its marginal impact on the economically weaker sections of society is far greater. India’s direct to indirect tax ratio is roughly 35:65. This is in contrast to most OECD economies where the ratio is the exact opposite, 67:33 in favour of direct taxes. In the 50-year period of our analysis, India’s direct-to-indirect tax ratio has swung from a low of 13:87 to its current high of 35:65. For the OECD nations, throughout this 50-year period, the direct-to-indirect tax ratio has remained roughly constant in the range of 65:35. Again, is there a desired balance between direct and indirect taxes for an economy?
Economic literature lays down two principal views. The first view, which was popular in the 19th century and into the middle of the 20th century, is the “desirable balance" view—roughly, the idea that there should be something like a half-and-half split. The great 19th century liberal prime minister of Great Britain, William Gladstone, subscribed to this view, for instance, suggesting that direct and indirect taxes were akin to “two attractive sisters each with an ample fortune"! Eventually, however, with the advent of mathematical optimization techniques in economics, the consensus view shifted to what is now the mainstream view, what economist Anthony Atkinson calls “superiority of direct taxes".
According to the modern mainstream view, direct taxes—such as income or wealth taxes—function better both in terms of efficiency and equity, while indirect taxes are inferior. What is more, ideologically, both left and right should prefer direct taxes to indirect taxes, for different reasons—the left for reasons of progressivity, the right for reasons of minimizing inefficiency. If indirect taxes must be used, perhaps because of some constitutional or political economy constraint on the level of income or wealth taxes that a government may levy, then ideally they should be minimally distorting—in effect, by mimicking the effects of a direct tax.
An example of a “good" indirect tax is a single rate goods and services tax (GST) with no exemptions. Such a tax distorts individuals’ labour supply and savings choices, like direct income and wealth taxes, but does not distort the economy’s structure of production or consumption, as most indirect taxes, such as trade tariffs, do. The “worst" taxes are sector-specific excise taxes with high tax rates—such as taxes on petroleum, alcohol and tobacco—which are maximally distorting to the economy and maximally regressive. Unfortunately, they are also among the most popular for governments the world over, because they are good ways to grab a lot of revenue, although not good for the economy or its citizens.
Nobel-winning economist Joseph Stiglitz summarizes well the consensus view in the economics profession. He argues that desirable features of an optimal tax system would be “progressive income taxes, complemented by indirect taxation, bequest taxes and capital taxes that enhance the progressivity that can be achieved by the tax system while limiting the level of distortion (deadweight loss)". Clearly, India—and for that matter, many other economies—are far away from this ideal.
The bottom line is that, while economists and others may disagree on what India’s tax-to-GDP ratio ought to be, we have shown that it is way below that of OECD economies. What is more, there is no disagreement that the bulk of taxes—whatever their share of GDP—should be raised using direct, rather than indirect, taxes. Here again, we have shown that India is an outlier, relying heavily on indirect taxes. Whatever may be one’s views on Piketty’s battle against inequality, we can all agree that he has done a valuable service by drawing attention to India’s peculiar and distorted tax structure.
The authors thank Mihir Sharma and Siddharth Singh for inputs.
Praveen Chakravarty and Vivek Dehejia are, respectively, visiting fellow and resident fellow in political economy at IDFC Institute. Comments are welcome at email@example.com