Tax trends suggest India may be close to a fiscal inflection point

There are two clear benefits of a rising consolidated tax/GDP ratio, or the amount of tax collected by all levels of government as a percentage of the nominal gross domestic product (GDP). First, buoyant tax collections can reduce the fiscal constraints on both the Union as well as state governments, making it easier for them to fund essential tasks such a national security, the provision of public goods and offering social security without running one of the highest fiscal deficits in the world. Second, a larger pool of tax revenues to be shared between different levels of government should hopefully ease some of the recent tensions in our system of fiscal federalism, which often resembles a zero-sum game where one side can gain only by denying the other.

View Full Image

The tax/GDP ratio in India has been inertial since the radical economic reforms of 1991, hovering around the 16% mark through most of these past three decades. Part of this reflects the switch in our development strategy—tax rates were slashed as part of the decision to move economic heft from the state to the private sector. But that is not all.

One rare period when the ratio increased in a meaningful manner was during the splendid economic boom between 2004 and 2008, but it later came down to earth, as the record economic expansion of those years ended with the shocks that battered the world in the wake of the North Atlantic financial crisis. The past two years have once again seen India’s tax/GDP ratio move up by around two percentage points.

What is particularly noteworthy about the recent fiscal trend is that direct tax collections are also growing rapidly. There are two implications of this. First, modern social contracts are built on tax systems where income tax is not restricted to a tiny elite, but is paid by a large majority of the population. Thomas Piketty has shown that most developed countries underwent such fiscal modernization between 1914 and 1945. Second, direct taxes are generally progressive, while indirect taxes are generally regressive—the former are based on the ability to pay, while the latter are not. A good tax system should strive to be progressive by collecting enough direct taxes on individual incomes, business profits and capital gains.

Look at the data in the two charts. The first shows that the ratio of direct taxes collected by the Union government has inched up in the past two or three years, and it is now close to its peak of fiscal 2007-08, just before the economic boom of that decade ended. The second chart shows that the share of direct taxes in total tax collections by the Union as well as state governments is still below its peak during the first decade of this century, but still much higher than the regressive tax structure we had before the 1991 reforms.

One of the goals of the tax reforms of the 1990s was to make the Indian tax system more progressive by increasing the share of direct taxes in the kitty. That is still a job half done. In a recent article in the Economic and Political Weekly, J.P. Morgan chief India economist Sajjid Chinoy writes that the share of direct taxes in the tax revenues of the Indian government is still well below the emerging markets average of between 50-60%. A more practical policy issue is that a rising share of direct taxes will create fiscal space for the government to cut rates of the goods and services tax (GST), thus spurring internal trade as well as international competitiveness.

The amount of direct tax any government collects is linked to the level of development in any country. The tax capacity of a poor country is obviously low. International experience shows that there is an inflexion point when the per capita income crosses $2,000 a year, a mark that India has now passed.

However, it is not just a matter of income levels. A gradual formalization of both enterprises as well as jobs can widen the direct tax base. It is thus important for us to see whether the recent growth in direct taxes comes from the creation of more formal enterprises and formal jobs, or merely reflects further concentration of incomes and profits with incumbents. In other words, whether economic growth has been inclusive or not. There is not much data available on this right now.

This column had asked in January 2018—rather hopefully—whether India was on the cusp of a fiscal revolution (bit.ly/2EzaRhb) . There were early signs then. The pandemic interrupted the process. The recent tax numbers offer fresh hope. As the January 2018 instalment of this column had asked at the very end: “Is such a fiscal revolution just around the corner? It is impossible to say for sure—but some of the answers are blowing in the wind."

Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.