Taxing choices

Throughout 2003 and so far in 2004, the rupee has been appreciating against the dollar. For a variety of reasons, the demand for dollars in India is now less than their supply.

The sharp increase in the value of the rupee (by nearly 9 per cent in the past year, with expectations of further strengthening in the weeks and months to come) is generally viewed as undesirable "" most notably because it prices exporters out of international markets.

Various suggestions have been made for increasing the demand for dollars. One of these is to reduce the rate at which customs duties are levied. This will reduce the price of imports and result in increased demand for dollars.

Apart from being the most sensible solution, it is also the one most likely to be adopted because the new government, when it takes office next month, will want to be seen as reformist.

However, in the short run, economic policy is all about give and take, and lower customs duties will lead to lower customs revenue. These are no longer very substantial as a percentage of GDP but still healthy at just under 2 per cent.

The question that needs to be addressed is how to make up on the swings what has been lost at the roundabouts, especially since there is so much concern about the level of the deficit.

Most countries that adopted a policy of lowering tariffs put in place alternative mechanisms for making up the foregone revenue. Those that didn't, like some Latin American countries, have had to struggle with the consequences.

If India is to avoid their fate, the obvious place to start is the adoption of the postponed value-added tax, or VAT. As VAT kicks in, the share of excise duties, now around 3.5 per cent of GDP, will increase. This may not make up fully for the lost customs revenue. But recognising the problem and doing something about it will at least reduce the immediate pain.

It will also have the unintended consequence of the government doing the right thing, albeit belatedly. There can be no stronger case for implementing VAT, which needs to be done anyway.

That said, how large the loss of revenue is going to be as a result of any reduction in customs duties will depend on three things: the import elasticity of demand, the rate at which the economy (particularly industry) grows and the speed with which services are brought under the tax net.

If elasticity is high, that is if imports increase more than in proportion to the cut in duties, there will be no revenue loss. The reverse will happen if elasticity is low "" which seems to be the more likely scenario.

Likewise, in the absence of other reform (labour markets, efficient infrastructure, etc) it is hard to say how quickly industry will grow. That leaves the service tax option. The revenue from these is climbing sharply and, with appropriate rate adjustments, ought to continue doing so. As with VAT, this is something that needs to be done anyway. Between the two, the hole in the government's coffers that will result from slashing customs duties can be filled.