It appears that the Bharatiya Janata Party (BJP), still the odds-on favourite to lead the next Union government, has some radical plans in store for the tax code. Addressing a public meeting in Delhi recently, its prime ministerial nominee, Gujarat Chief Minister Narendra Modi, said that the tax system "is a burden on the common man. There is a need to reform it. It is the need of the time." Mr Modi rarely directly addresses macroeconomic issues, so this statement must carry some weight - doubly so as the BJP's former president, Nitin Gadkari, who is currently in charge of drafting its "vision document", has spoken in favour of a radical tax reform proposal. The proposal calls for the abolition of all taxes and their replacement with a single banking transaction tax.
Given the momentum behind this proposal, it must be taken seriously. After all, an abolition of income tax will be hugely popular among wealthy taxpayers, the exact swing demographic that the BJP is currently worrying it might lose to the insurgent Aam Aadmi Party (AAP). The numbers that some of the BJP's leaders are touting are attractive, too. They argue that the Centre's tax receipts are about Rs 11-12.5 lakh crore annually. A two per cent tax on banking transactions, they calculate, would lead to revenue of Rs 15 lakh crore, easily covering the loss from tax abolition. In addition, the cumbersome and invasive tax bureaucracy would be abolished, and compliance would become easier. To minimise cash transactions and black money, Rs 500 and Rs 1,000 notes would be removed from circulation, and cash transactions above Rs 2,000 would become a criminal offence.
However, the absurdity of the proposal overall is so great that it is difficult to believe that the BJP is serious. For one, the Centre can control only income taxes. Changes in value-added taxes need the states to sign on. Given the BJP-ruled states have led the opposition to the goods and services tax, which would streamline indirect tax law, it is easy to see how difficult the proposal would be legally. Secondly, even the replacement of income taxes by a banking transaction tax seems to have no basis in economic common sense. The primary principle of public finance is to reduce the distortionary impact of taxation as far as possible. Income taxes could theoretically cause people to change their work-leisure decision. But the economic losses and distortion caused by a revenue-neutral shift to banking transaction taxes would be much higher.
Such taxes have been extensively studied in Latin America, where cash-strapped countries have occasionally introduced them over and above their regular tax codes. They have inevitably led to a withering of the tax base within months, as people abandon the banking system - a process called "disintermediation". An International Monetary Fund study found that as much as half of what is raised in revenue could be lost to the banking system through disintermediation. The BJP's apparent answer to this problem is to force people to use banks through the threat of criminal penalties. This in a country with limited penetration of organised finance, with multiple avenues for illegal transactions that require no paperwork - and at a time when online alternative currencies like bitcoin are gaining in strength. Rather than cutting criminality and black money, this proposal will increase them massively. Indeed, so poorly thought out is this proposal that the BJP must issue its real economic plan as swiftly as possible, so as to minimise the adverse impact on its image being caused by this proposal. Clarity on Mr Modi's economic agenda is becoming ever more essential.
