Home / Opinion / Columns /  The moral case for a higher share of direct taxes

The commentary on the Union budget proposals for 2022-23 has been mostly around the theme that it is a bold and aggressive “gamble on growth". A high tide raises all boats. If economic growth is above 8% in real terms, and above 14% in nominal terms, it would spell good news for job creation (from real expansion) and also tax collection (from nominal expansion which benefits from somewhat higher inflation). The latter would be good for some fiscal correction. As for inducing growth, the finance minister has done her bit, by ensuring that all the incremental growth in government expenditure next year is on capital items, which promote long-term growth. But the bulk of the growth-inducing investment spending beyond infrastructure will have to come from the private sector, including foreign investors. It is on this that the “gamble" aspect of this budget will be most watched. Are animal spirits going to be sufficiently unleashed, so that we have a multi-year private sector capex rally? The pre-conditions do exist. Banks have healthier balance sheets, and corporates are now sufficiently de-leveraged. Foreign inflows have been very strong, albeit focused on unicorn sectors. But business confidence for investment expansion will need a boost from consumer sentiment too. That, in turn, will depend on job creation and the employment outlook, which in turn depends on business expansion, completing this self-fulfilling loop. This could be either an optimism- or a pessimism-reinforcing loop. It is difficult to tell which way next year will turn out, although the weight of probability favours optimism.

In the meantime, the bigger challenge is one of fiscal consolidation. At a time when fancily-called Modern Monetary Theory has gained currency (pun intended), and unlimited deficit financing is becoming respect-able, it seems terribly old fashioned to talk about fiscal responsibility. But just like the law of gravity, the law of unsustainable debt cannot be defied. If the government-debt-to GDP ratio (India’s is at 90% of gross domestic product, including state governments) rises too fast, there is no way out except to repudiate it, default on repayments, or cause high inflation (by printing lots of currency, MMT style). High deficits not only cause eventual debt-management problems, but are also a burden on unborn generations. For, today’s deficit, paid for by borrowing from the public, will be repaid in the future by the government by taxes on future generations. The unborn cannot even vote, but have a tax burden imposed on them. What happened to “no taxation without representation"? The issue of low deficits therefore becomes a moral issue, or an issue of fairness, of inter-generational justice.

If you agree with this proposition, then the natural next step is to either cut spending or raise taxes. In a complex, diverse democracy with special interest groups, spending cuts are not so easy. Besides, India has to catch up on its backlog in health and education spending, so reducing the size of the government is almost impossible. Which means we have to find a way to raise revenue, not by taxing unborn future citizens (i.e. running deficits), but from the present generation. Here, we have two choices, direct and indirect taxes. Monthly goods and services tax (GST) collections touched a record high of 1.4 trillion in January, prompting the finance minister to deviate from her prepared speech to mention this joyful buoyancy. But high GST, to the extent it comes from high tax rates, is no cause for cheer. It is an indirect and regressive tax, even though as a transaction tax, it is easier to collect and administer. For the past three or four years, the share of indirect taxes in total tax collections has been rising, and has reached 55%. Our median GST rate is stuck around 18%, which is punitive for low-income households. Imagine paying 18% on your health insurance premium during pandemic times. But that does not mean we tinker around with rates, giving relief to food and medicines.

The multiplicity of GST rates means having to decide what goes into the 5% slab and what in the 12% and 18% brackets. Plain biscuits in 5 and cream biscuits in 12? That is just invitation to disputes and litigation, if not harassment and corruption. We need a low and stable indirect tax system with wide coverage and preferably a single slab (a flat sales tax, also called transaction tax). Crucially, what we need is a higher share of direct taxes in overall collections, imposed on incomes of individuals, whatever the source of their income (be it a salary, capital gains, inheritance or a lottery). India has only seven direct taxpayers for every 100 voters, one of world’s lowest ratios. There was a time when dividend income was tax free, and it took 20 years to undo that misadventure. Thanks to e-triangulation and digital payments, it is possible to deduct tax at source for dividends. This is not quite a presumptive tax, as done with salaries, but is effective. A similar approach should be applied to all realized capital gains. We are getting there, but not fast enough. The principle of income tax should be based on being agnostic to the source of income. This is the notion of horizontal equity. Two people earning similar incomes should have similar tax burdens. We also need progressivity in direct taxes: i.e., higher income earners need to pay more taxes (a natural corollary) and also at higher marginal rates. This is the notion of vertical equity. India’s tax-to-GDP ratio is among the world’s lowest. We have room to raise it. But that must be in a fair way, increasing the share of direct taxes like capital gains and reducing the share of indirect taxes like GST.

Ajit Ranade is a senior fellow, Takshashila Institution

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