Kanhaiya Singh: Revenue problem eludes solution

Direct tax revenue is not increasing enough to compensate for the fall in indirect tax revenue

Much has been made of the attempts by successive finance ministers to deal with India's fiscal problem. However, not one of them in the past 15 years has tried to deal with the most fundamental issue, namely, declining collection in central revenues. Unless this problem is resolved, finance ministers will only be fooling the public.

Thus, in 1990-91 almost 80 per cent of the central revenues came from taxes of various kinds. The rest were collections from non-tax sources, including interest earnings on advances to states, inflation taxes, and dividends from profit-making public sector undertakings.

But now the share of tax-based revenue collection has gone down to 71 per cent, which is also reflected in the falling share of tax revenue as percentage of GDP. The reason is the fall in indirect tax collection and the increase in non-tax revenue, which of late includes proceeds from disinvestment. The fall in the share of indirect taxes has not been matched by an increase in the share of direct taxes.

The literature on the composition of taxes is complex and shows that direct and indirect tax instruments are used in different proportions. Many considerations go into the final mix, such as the need to avoid double taxation, equity issues, and the cost of collection.

When tariffs are reduced to harness the benefits of trade, and the goods and services taxes are reduced to increase consumption, the income tax become the chosen vehicle for tax collection. It can be used flexibly to ensure equity.

The table presents the revenue structure of selected countries. The US depends heavily on the income tax and social security tax, and indirect taxes are almost non-existent, particularly the rate of taxation on goods and services was a nominal 0.8 per cent in 2000. On the other extreme, during the 1990s, China appears to have shifted its policy heavily in favour of taxing goods and services, leaving income as the nominal source of tax revenue.

In 1999, 74 per cent of China's current revenue came from goods and services, with a tax revenue to GDP ratio of 6.8, and a moderate average goods and services tax rate of 6.5 per cent, which is a little higher than India's. China's shift might have been motivated by its stress on foreign investments and an already developed huge domestic market.

But there are several countries including India with mixed taxation policies. However, none of the countries in the table is losing the share of tax revenue in their revenue receipts, as is now the case with India.

The heart of the problem in India is that direct tax proceeds are not increasing to compensate for the fall in indirect tax revenue. It is not clear therefore which way the policymakers wish to move. With proposals of debt swap for the state governments, the reluctance to privatise and the prevailing low level of inflation, non-tax revenue is likely to get reduced. Therefore, clearly, the deficit is likely to worsen""unless an extra growth in GDP makes up for it. But that too is not on the cards.

Indeed, if India is to develop into a modern market economy, its dependence on non-tax revenue must reduce. At the moment, several profit-making PSUs contribute to the government kitty instead of redeploying their surpluses to generate additional investment and employment. In a way, this is a surrogate tax applied uniformly. Amazingly, Budget speeches are often silent on these issues and focus instead on grandiose announcements of doubtful value and efficacy.

The services sector contributes 50 per cent of GDP. So it is often emphasised that taxes on services will solve the problem of India's revenue growth. The process has started, but the revenue contribution from services has crawled to 3.1 per cent of the total revenue, from 1.4 per cent in 1998-99, when it started. In contrast, customs and excise duties contributed about 53 per cent and direct taxes about 41 per cent.

This is the tax yield from 58 services that are in the net. The 2004-05 Budget has proposed another 15. Only time will tell what difference this is going to make, since major professions such as those of doctors, accountants, and lawyers, have not been touched yet.

Nevertheless, some assessment of the limitations of the revenue potential of the services tax is in order. It is important to realise that a 50 per cent contribution to GDP does not mean that it should yield commensurate tax revenue for a very simple reason: half of this is in the unorganised sector, which cannot be taxed due to administrative difficulties.

Out of the remaining half, several components of the services are beyond the purview of taxation. These include organised sectors of government, defence, social services, railways and government-owned other transport. After removing these sectors, about 15 per cent of GDP is left for taxation.

Taxing this in a VAT framework at 10 per cent with a 100 per cent efficiency will yield revenues of another 1.5 per cent of GDP, approximately 0.3 per cent already realised. Thus, the services sector, at most, could reduce the fiscal deficit by another 1.2 per cent. Is this going to solve the problem?

Considering the limitations of indirect taxes in terms of equity, identification, and distortions in the production process, it would be worth debating the possibility of loading income as the key source of tax revenue, leaving the production and services process almost free of taxation. In the Budget, the increase in gross tax revenue has been projected as Rs 6.28 billion higher than the revised estimates of 2003-04. Out of this increase, the share of direct taxes (income tax and corporate tax) is Rs 3.61 billion and that of indirect taxes (all other than income and corporate) is Rs 2.67 billion. No increase has been proposed in non-tax revenue. This appears to be a slight correction but definitely not a direction.

To ensure that the economy moves in this direction, policy must demonstrate a quantum reduction in indirect taxes and a bigger jump in direct taxes. However, that requires a degree of political will and determination that we are unlikely to see in the near future.

(The writer is Senior Economist at the National Council of Applied Economic Research, New Delhi. The views expressed here are personal)