Structural weakness

India needs to overhaul the tax system

Tax collection recovered swiftly towards the end of the last fiscal year with a pickup in economic activity. Gross tax collection grew 0.73 per cent in 2020-21, surpassing the revised estimate by Rs 1.24 trillion. Better than expected revenue collection also resulted in a lower than projected fiscal deficit. The Union government’s tax collection as a percentage of gross domestic product (GDP) improved to 10.25 per cent, compared to 9.88 per cent in the previous year. However, overall improvement in tax collection was largely on account of higher duty on petroleum products. Excise duty collection went up by over 60 per cent during the year. Higher indirect tax collection also pushed its share in total collection to 5.46 per cent of GDP, compared to direct tax collection at 4.79 per cent.

Higher collection of indirect or consumption taxes is seen as regressive because it tends to affect the poor more. However, there are several facts worth examining here. As a proportion of GDP, indirect tax collection was higher in 2018-19 but was accompanied by even higher direct tax collection, which made the total tax collection look more equitable. During last fiscal year, indirect tax collection was pushed up by a higher levy on petroleum products, while direct taxes suffered because of lower economic activity. Although large companies did reasonably well, smaller firms seem to have suffered, which affected total tax collection. Corporate tax collection also suffered, in part, because of lower tax rates. In the context of indirect tax collection, it is also worth noting that a large part of the levy on petroleum products is in the form of cess, which is not shared with states.

But the government’s dependence on petroleum products has increased over the years because of inherent inefficiencies in India’s tax system and its inability to generate enough resources. The goods and services tax (GST) rates, for instance, are not revenue-neutral. As a result, the general government is losing revenue worth over 1 per cent of GDP. Further, at a broader level, India is not collecting high indirect taxes compared to other countries. Taxes on goods and services amount to about 11 per cent of GDP in Organisation for Economic Co-operation and Development (OECD) countries. Despite the improvement witnessed in the post-reforms period, India’s tax collection is suffering because of a lower direct tax mop-up. Personal income tax collection, for example, remains low because of a number of exemptions and inadequate tracking of activity in the unorganised sector. Income from salary accounts for about 60 per cent of declared income. While collection from personal income tax marginally exceeded the corporation tax mop-up during the last fiscal year, the ratio is much higher in OECD countries.

India needs a significant overhaul of the taxation system as the tax-to-GDP ratio has remained virtually stagnant for years. As the Fifteenth Finance Commission has shown, India’s general government resource mobilisation — including tax and non-tax revenue — is at about 20 per cent of GDP, compared to an average of over 27 per cent in emerging markets and over 36 per cent in advanced economies. The government is not generating enough resources to fulfil its social and developmental obligations. Inadequate tax collection will affect the government’s ability to push productive investment to support growth and ease public debt. Thus, the government urgently needs to rationalise indirect tax rates and revamp the direct tax system.