Subir Gokarn: The pursuit of neutrality

The turmoil plaguing the implementation of VAT reflects the elusiveness of a largely neutral system.

The fiscal situation today is fundamentally different from what it was even as recently as eight years ago, when Mr Chidambaram unveiled his "dream budget".

One key difference is the degree of "neutrality" that the tax system has achieved over this period. This essentially means that the influence of tax considerations on basic economic decisions""what, how and where to produce and consume""has declined enormously.

For the vast majority of production and consumption decisions, relative costs and prices, not differential tax burdens, should be the dominant consideration.

The thrust of fiscal policy reforms over the last decade has been to increase neutrality""both by lowering the average rates of all categories of taxes and by reducing the huge dispersion of indirect tax rates across commodities.

The former contributes to neutrality by reducing the discrimination between those who pay taxes and those who find ways to avoid them. The latter does so by eliminating, or at least reducing, the role of taxes in determining the competitiveness of specific products.

However, despite the very significant progress that has been made in the direction of neutrality, there are still many distortions that need to be addressed.

With reference to direct taxes, the major remaining sources of non-neutrality are the various exemptions allowed for by the Income Tax Act.

These basically treat certain types of either income or expenditures differentially, which induces companies to change their production and investment decisions.

The reform blueprint that the government has before it, based on the recommendations of the Kelkar task force, is based on the elimination of these exemptions, while simultaneously lowering the tax rate.

While the recommended uniform corporate tax rate is 30 per cent, an analysis of recent years' corporate tax payments suggests that the effective rate is somewhat less than this (in the 20""30 per cent range) for most sectors.

If the government wanted to maintain strict revenue neutrality (there is no particular reason why it should), then it could either consider a slightly lower rate or continue to allow some exemptions.

If it chooses the latter route, it should, at the very least, shift the bias away from spending on physical capital, which the exemptions have created and towards employment and human capital.

There is one significant initiative it might consider. One reason why employment in the organised manufacturing sector stubbornly refuses to increase is that the effective cost of labour significantly exceeds the wage itself.

The employer has to consider the costs of keeping people on the rolls with full pay through the entire course of a business cycle. His labour cost, therefore, is the wage plus the cost of providing unemployment "dole", which is the difference between the worker's wage and his productivity during the bust phase of the cycle.

Even with mechanisms like variable pay, which partially offset the burden, the increasing uncertainty about the duration and severity of business cycles in many industries can make this a significant deterrent to expanding the workforce.

If the government were to recognise this component as a legitimate cost of hiring workers, it could allow employers to claim this component as a deduction over and above the observable wages and salaries' bill.

Of course, issues of measurement and accounting can introduce enormous complications; if these are insurmountable, then no exemptions at all along with a lower rate is the best possible outcome.

One of the criteria by which the maturing of a tax system can be assessed is its shift from indirect to direct taxes.

The latter are desirable because they can be simultaneously progressive""they tax most those who can afford to pay the most""and neutral""they tax all income at the same rate regardless of its source. In expanding the scope of direct taxation, there are some structural issues that need to be dealt with. One major concern is that, while services account for more than half of GDP (or about 40 per cent, if we leave out government), their contribution to the tax kitty simply does not reflect that magnitude.

Service taxes, even as they are growing quite rapidly, currently are only 8 per cent of the total revenues generated by excise and customs duties, which fall exclusively on industry (which is about a quarter of GDP).

Yes, service enterprises pay income taxes like manufacturing companies, but there is an enormous presence of the unorganised sector across the services spectrum.

One important indicator of neutrality is some correspondence between the share of a sector in GDP and its contribution to the revenue pool. While it is difficult to pin down an optimal number for this balance, it would not be unreasonable to argue that India's situation is completely out of whack.

This imbalance is simply not going to be addressed without bringing large parts of the services sector into the direct tax net, even while expanding the scope and enforcement of the indirect services tax.

Tax neutrality is not just a matter of rates; it is also a matter of identifying all those who can potentially pay taxes.

On the indirect tax front, while central taxes have broadly converged towards neutrality, the huge turmoil that has plagued the implementation of the state-level value added tax (VAT) reflects the elusiveness of a largely neutral system.

Even when the state VAT is implemented, the fact that many state and local levies will not be included in the list of permissible credits means that producers will take these into account when making location and scale decisions.

One of the most desirable attributes of VAT in the Indian situation is that it creates a strong incentive for those who pay taxes to transact with others who also pay taxes.

If a producer buys an input from a supplier who is not in the tax net, he obviously cannot take credit for taxes paid.

There is a huge "network externality" implicit in the spread of VAT. As more producers come into the net, the number of transactions that pay taxes will go up exponentially.

This medium- to long-term benefit makes a strong case for immediate implementation, even with all the compromises in terms of coverage that are now being spoken about.

This also addresses the broader question about bringing in as many people into the tax net as possible. Once they are in the indirect tax system, there is no reason why they cannot be monitored by the direct tax system as well.

To sum up, on tax initiatives, the Budget should be evaluated in terms of its pursuit of neutrality.

This essentially means removing three kinds of discriminatory elements""between those who are in the net and those who are not, between the share of GDP and the share of tax contribution, and between indirect and direct taxes.

(The author is chief economist, Crisil. The views here are personal)