The much-awaited report on the direct tax code (DTC), which will replace the existing Income-Tax Act of 1961, was presented to finance minister Nirmala Sitharaman in August. Reforms to India’s direct tax regime have been pending for years.Given the deepening economic slowdown, any further delay in simplifying India’s tax structure could prove costly. Arvind Virmani, the chief economic adviser in the finance ministry from 2007 to 2009 and currently chairman of the Foundation for Economic Growth and Welfare, spoke about taxation and the economy at large. Edited excerpts from an interview:
What kind of tax regime do we need today to solve the economic crisis?
To understand the current situation, we need to look at taxation. We were waiting for the DTC for a long time. The old code has been built in layers and layers of confusion. There’s no economic logic that defines it. I think the DTC is extremely important from all aspects, and not just economics.
As there is a direct link between the genesis of the tax code and growth, how would you place it in the current situation?
A reformed code will definitely bring about growth. However, the structures we have built over time gave rise to systemic corruption. One way to tackle this is to go after individual corruption. But the problem is of systemic corruption and systemic tax evasion. So you need a systems approach. This has been neglected and too much focus has been given on individual corruption. How are the systemic approach and taxes connected? Because there are two fundamental systemic problems, which give rise to corruption—tax evasion and government actions. So, if you look at the genesis of the problem, it is government expenditures and taxation. You need to reform these two systems.
What sort of design principles should be followed in tax policies? In developing countries, taxes usually are progressive and direct taxes, therefore, bear the greatest burden. However, in India, indirect taxes seem to be leading the way.
The principles that we should use for tax reforms are simplicity, equity, and revenue neutrality. Take the case of the goods and services tax (GST). Equity doesn’t come from taxing every product progressively. Equity should be of the whole system. So, what was the system? It was supposed to be a simple three-level system (zero tax on food, education and health services so that the poor are protected, a standard rate, and surcharges on a few sin or luxury goods). It was designed to take care of these principles simultaneously. However, we have made it incredibly complex. The poor man doesn’t know the six different rates. The ordinary guy is spending between ₹1 lakh and ₹2 lakh just to file his stuff. It’s the worst thing you could have designed. Where is the incentive (to join in and comply)? It’s gone. The only way to repair it is to go back to the three-level system.
What should be the policy design for direct taxes? Aren’t direct taxes at risk of getting complicated too because fundamentally people believe they should be progressive and, therefore, they might end up with too many rates?
With the direct tax reforms we did in the ’90s, their share in revenues went up dramatically. This demonstrated that the principles of simplicity, equity and revenue neutrality work in India as well. However, here’s the important thing. Revenue neutrality is supposed to be an outcome of simplicity. The effect of simplicity is an increase in voluntary compliance. When voluntary compliance increases, revenue goes up. So, revenue neutrality doesn’t mean you have to exactly balance the tax. You have to make an assumption about compliance. The second part is you may have to make an allowance for delays. So you say, OK, it may not happen this year, but in two or three years, it is going to be revenue neutral.
Can the Laffer curve—the American argument that a lower tax rate will result in net increases in revenues—be applied to India?
If you look at the direct tax reforms, you would find that rates were reduced directly, which not only led to higher tax collection but also altered the system dramatically. In corporate tax incomes, the Laffer curve has been plotted. The peak is reached between 20% and 22%. Income tax (I-T), however, is fundamentally more difficult because it is hard to define income in a practical way. There’s an issue whether you tax income or consumption. First, if you tax consumption, then you have to exempt all savings.
Second, since it’s a theoretical concept, it is not a realised income, which creates tons of problems with assets. So, if I have a house and its value has gone up and you start taxing me on it, I am going to be sunk pretty soon. So, this has to be dealt in a pragmatic way. I think because there is this huge past of socialist (tendencies), it is safer to stay with the income definition because there’s an inherent equity in it. I prefer that to having a highly progressive system (with extremely high tax slabs at the top) because these systems are highly inefficient. Everybody should pay a reasonable rate.
Only a small section of our population pays taxes. How should the policy be designed to address this problem?
I would support a three-tax system. Let’s say a zero stage, and 10%, 20% and 30%, and a maximum surcharge of 5%, but no cesses. There’s nothing in economic theory that justifies cesses.
What do you think about a wealth tax?
The political system always does the easy thing. If there is a case for reform within the system, then a case can be made for an inheritance tax. If you don’t carry out structural reforms, and keep on adding taxes, you will be incapable of implementing them.
Given the sharp fall in demand in the economy, what steps do you think should be taken to strengthen growth?
First, the (real) repo rate must be brought down to zero, implying that the nominal repo rate should be the same as the 4% inflation target. The Reserve Bank of India (RBI) should reduce 50 basis points in every meeting as long as 4% inflation is not exceeded.
The second is the monetary base. You cannot keep talking about demand without talking about monetary policy. The monetary base has to expand sufficiently, because it is important for transmission.
The third is the non-banking financial company problem. They have become the main channel of credit for households who are consumers and direct investors. They don’t have credit.
Fourth is implementation of the DTC. Put it out for public debate and implement it in the budget.
Fifth is the GST calculation. Put out the proposals in front of the GST committee. People have to be convinced that you are going to try your best in this regard.
What can the government do in terms of taxation policy to provide immediate economic stimulus? For instance, the automobile industry wants a tax cut.
You have to start putting in some reforms. But I am against targeted reductions; that is if you just reduce GST for six months in auto. My problem is with credibility in the long run. If you have to reduce GST for the auto sector permanently, then it’s not a problem. But make sure you do your calculations.
Do you think the economic crisis is big enough to warrant a radical monetary expansion like in 2008-09?
Back then, the whole economy was collapsing. But today, we are not in that situation. There is enough room for reforms, which will give you a temporary boost if you keep your rates lower.
Given the urgency to counter the growth slowdown, could the tax rates be lowered to provide a stimulus to consumption?
Absolutely. My priorities would be: One, reduce the corporate tax, at least to 25%. The second is the road map for GST (simplification). And the third is to implement the DTC. It must be put out soon for public debate so that it is implemented in the upcoming budget.