A bane of the Indian tax system is that it is extremely complicated and this is due to burdening the tax policy with several objectives. Although many countries’ tax policy is used as an instrument to accelerate investment, encourage savings, increase exports and pursue some other objectives, Indian’s obsession is perhaps unique. In addition to the above, India’s tax policy is loaded with objectives such as industrialisation of backward regions, encouraging infrastructure ventures, promotion of small scale industries, generation of employment, encouragement to charitable activities and scientific research, and promotion of enclave-type development through Special Economic Zones (SEZs). These objectives are pursued through various exemptions, differentiation in rates and preferences which enormously complicate the tax structure and open up avenues for evasion and avoidance of tax and create rent-seeking opportunities.
Ironically, various types of tax incentives continue to persist in spite of a number of studies questioning their effectiveness and highlighting their enormous costs. Many studies have shown that such incentives are redundant and, in many cases, ineffective. They not only cause enormous loss of revenue but also introduce severe distortions in resource allocation, often without achieving the intended objectives. Even when they achieve the objectives, there are better and lower cost methods of achieving them. As stated by Richard Bird and Eric Zolt (“Introduction to Tax Policy Design and Development”, World Bank, 2003), factors such as stable governance system, sound macroeconomic policy and good infrastructure are more important in business location decisions than tax benefits. In any case, tax incentives cannot compensate for the absence of these critical factors.
A good tax policy is the one which minimises the three costs associated with it, namely, cost to the exchequer, the compliance cost and the cost of economic distortions. The cost to the exchequer increases with tax preferences due to higher cost of administering them and even more due to the cost of revenue foregone. Tax preferences are equivalent to subsidy payments. The problem, however, is that these are non-transparent and unlike cash transfers to the desired sectors, they are poorly targeted. Widespread tax preferences also create additional compliance costs to the businesses. Even more important is the unintended impact on resource allocation created by these incentives. The relative price distortions created by tax incentives impact on resource allocation across sectors as well as regions.
Since 2006-07, the Central government’s Budget presents a detailed statement of the revenue foregone on account of various tax incentives and in 2009-10, it is estimated at Rs 5,40,269 crore. If the export credit, which in any case should be given to relieve the domestic taxes on exports, is excluded, the amount works out to Rs 5,02,299 crore or about 80 per cent of the estimated tax collections in the year. Overwhelming proportions of this are due to concessions in customs and excise duties, but concessions in corporate income taxes too are significant. Total tax expenditure due to corporate income tax is estimated at Rs 79,554 crore and of this, the amount due to accelerated depreciation was Rs 25,180 crore or 31.7 per cent. Incentives provided to infrastructure sectors — including power, mineral oil, SEZ and industrial parks and companies involved in cold chain and post-harvest technology — constituted 22.6 per cent (Rs 17,978 crore). Area-based incentives resulted in the loss of revenue amounting to Rs 5,463 crore, or about 6.9 per cent.
While these estimates look staggering, it is important to note that these are only indicative because the estimation is not done in a scientific manner. First, the estimate assumes that the behaviour of taxed entities is identical with or without tax concessions. In the case of customs and excises, for example, the revenue foregone is estimated by simply multiplying the difference between the tariff rate of duty and effective rate of duty on the tax base. A more appropriate method is to estimate the impact of the tax concession on the tax base itself. Second, taking the tariff rate of duty as the normal rate overestimates the revenue loss. In the case of custom duties, often, tariff rates of duty are kept high for protective reasons. The objective is not to provide concession, but simply to enable increasing the rate when needed for protective reasons. Relieving domestic taxes on exports is a practice followed in every country for reasons of competitiveness and, therefore, these cannot be called concessions. There are some exemptions which do not enter into the value of the tax base at all and they are simply ignored in the way tax expenditures are estimated. The small scale industry exemption in the case of excise duty is a case in point. Surely, presenting the estimate tax expenditures as a part of the Budget is a welcome initiative, but it is necessary to improve the methodology to get more robust estimates. The Department of Revenue could do well to collaborate with specialised research institutions in improving the methodology or provide access to data to such agencies by blocking out the names of individual firms to improve the quality of the estimate.
The most undesirable consequence of tax incentives is the unintended distortions in resource allocation they create. Although the Statement of Revenue Foregone in the 2010-11 Budget states, “…the basic issue is not one of tax policy but of efficiency and transparency”, severe distortions caused by tax concessions bring down the overall growth of the economy. Attempts to promote the small scale sector only result in the splitting of firms to operate at less than optimal levels, and there is no evidence that the modern small scale sector is labour-intensive. Area-based exemptions drive out industries from areas with comparative advantage. The proliferation of tax concessions erodes the tax base necessitating higher nominal tax rate which causes greater distortions. The lower tax rates to recover the same amount of revenue in the absence of tax preferences would contribute to better and less distorted structure of incentives.
Rationalising tax exemptions and preferences is a priority area of reform. In order to minimise the influence of special interest groups in proliferating incentives, it is important to educate the public and the policy-makers and present least-cost reform options, and this can be done only when scientific analyses of tax incentives and robust estimates of tax expenditures are presented.
The author is director, NIPFP. The views expressed are personal
