M Govinda Rao: Tax rates and compliance ratios

Revenue increases have come through administrative measures like expanding the TDS and not through just tax-rate cuts

An important policy issue is whether the increase in the revenue productivity of personal income tax since 1991-92 was due to the reduction in the marginal tax rate or simply due to administrative measures.

Notably, revenue from personal income tax as a ratio of GDP virtually doubled from less than 1 per cent in 1991-92 to close to 2 per cent in 2004-05 even as total (gross) central tax-GDP ratio declined from 10.3 per cent in 1991-92 to 8.2 per cent in 2001-02 before crawling back to 9.9 per cent in 1994-95.

While most protagonists of supply side tax policy attribute this to the reduction in the marginal tax rate from over 50 per cent that existed before the reforms to 30 per cent after 1996-97 when P Chidambaram in his earlier tenure as the finance minister went even beyond the 40 per cent marginal rate recommended by the Chelliah committee. The increase in revenues has been attributed to the "Laffer Curve" phenomenon.

However, there are others, who believe that the "Laffer Curve" argument has been overstated and the problem is one of enforcing the tax rates. It has also been argued that reduction in rates has adversely impacted on equity.

The empirical analysis of the relationship between effective tax rates and revenue collections, albeit with the small sample of observations shows negative relationship indicating that decline in the tax rate is associated with an increase in the income tax collections, as a proportion to GDP.

In his careful analysis, Arindam Das-Gupta has shown that tax compliance has improved after the reduction in marginal tax rates. The general opinion seems to be that the rate elasticity of personal income tax is negative and significant.

Is the improvement in revenue productivity since 1996-97 solely or mainly due to reduction in marginal tax rates? A close perusal of the sources of growth of revenues shows that revenue increase has come about mainly due to the administrative measure of expanding the scope of tax deduction at source.

Interestingly, the revenue from tax deducted at source (TDS) actually declined from 42 per cent in 1991-92 to 22 per cent in 1995-96, but increased sharply to over 50 per cent following the expansion in the scope of TDS in 1996-97 and thereafter increased to 67 per cent in 2001-02, before declining marginally to 64 per cent in 2003-04.

Thus, the trend in TDS suggests that the improved compliance is largely explained in terms of improved coverage and greater effectiveness of TDS as a tool for collecting taxes.

Interestingly, although it is tempting to attribute this to extension of TDS to interest, dividends, payments to contractors and insurance commission, the increase has come about mainly in TDS in salaries.

The TDS in salaries in 1992-93 constituted only 25 per cent of total TDS, and it increased to 50 per cent in 1999-2000 and thereafter declined to 41 per cent, as TDS from payments to non-residents and others and payments to contractors increased substantially.

It is also seen that the substantial increase in 1996-97 in TDS and corresponding decline in "advance tax" is accompanied by a sharp increase in the refunds as well.

However, even after the refunds are adjusted, the share of TDS in total receipts continues to remain high and increasing. This implies that the contribution of TDS to incremental revenue is increasing as well.

Thus, increase in the tax revenue has more to do with the rapid growth of the organised sector, financialisation of the economy, and administrative measures of extending the scope of TDS than improved compliance arising from the reduction in marginal tax rate.

While these factors provide a general explanation, it is important to explain why in the last four years the revenue from personal income tax has shown phenomenal increase, almost at about 20 per cent per year on average. The interesting point to note is that while the scope of TDS was increased, there was no attempt to build the information system until recently.

Interestingly, even as the coverage of TDS was extended over the years, there was virtually no information system to verify whether those deducting the tax at source file the returns and pay the tax.

According to the CAG report, in 2003-04, more than 40 per cent of 6.26 lakh TDS assessees did not file the returns. Even this is a vast improvement from the previous year when almost 80 per cent of the TDS assessees did not file the returns! Hopefully, improved information system instituted by the National Securities Depository Ltd will continue to enhance revenue productivity.

What is the impact of the reduction in tax rates and simplification of tax structure on the equity of the tax system? This is important since, given that indirect taxes are often argued to be lacking in progressivity, the job of delivering progressivity to the tax system is often assigned to personal income tax.

Indeed, the estimated effective tax rates shows that effective tax rates for all assessees are now lower and the rates seem to be converging over time for different income levels, particularly after 1997-98.

However, from the above, it would be inappropriate to conclude that overall equity in the tax system has worsened over the years. In fact, what this shows is that between income tax payers, the progressivity has declined.

Surely in 2003-04, as many as 288 lakh people pay income tax as compared to about 39 lakh in 1989-90 and the tax paid by them now has doubled from less than 1 per cent of GDP to almost 2 per cent of GDP.

Thus, much larger proportion of incomes is now subject to tax than in the past. Further, increase in the number of taxpayers indicates improvement in horizontal equity since more people with similar incomes now pay the tax.

On the whole, the empirical evidence is unclear about further gains from reducing rates though there is a case for cleaning up the tax system from the tyranny of cesses and surcharges.

However, considerable increase in revenue productivity is possible by improving the information system, administration and enforcement and the adjudication process.

The author is Director, National Institute of Public Finance and Policy. Comments can be sent at mgr@nipfp.org.in