How to raise India's poor tax to GDP ratio

A combination of reduced cash intensity, a focused strategy of tax administration and GST is the way to go, say Sakshi Gupta, Tanvi Garg and Abheek Barua.

Illustration: Dominic Xavier/Rediff.com.

With a week to go for the 2017-18 Budget, the issue of the potential fiscal benefits from “demonetisation” has predictably taken centre stage.

The most important question being asked is whether demonetisation will prove to be the silver bullet for tax collections by increasing the tax-GDP (gross domestic product) ratio.

A quick comparison with emerging market peers underscores the need to push this ratio up to create fiscal space.

The tax-GDP ratio (Centre+state) in India is the lowest in its league -- at 16.6 per cent as compared to China at 19.4 per cent, Brazil at 35.6 per cent and the overall emerging markets’ average at 21.4 per cent.

Despite attempts to increase the tax net and myriad efforts to improve tax administration India’s tax collections as a share of GDP have risen by only 10 percentage points over the past six decades (1950-51 to 2013-14).

The possible tax gains from a less cash-intensive economy have to be analysed carefully.

Unlike what many have argued, we do not find any meaningful relationship between currency held by individuals and the tax-GDP ratio.

The sharp rise in currency holdings by the public over the last few years, to take an example, did not pull the tax-GDP ratio down. This is to be expected and any attempt to draw inferences from this simple relationship presents what economists would call the “missing variables” problem.

Many other things (tax rate changes for instance) have an impact on tax collection and attempts to map the tax-GDP ratio on to currency holdings might prove to be misleading.

That said, lower cash holdings in the economy that it creates is an “enabler” and could prove to be positive for the tax-GDP ratio with the right changes in tax administration.

In fact, in our analysis of the plethora of variables that we tried to relate to the tax buoyancy of the economy, reform in tax administration such as the introduction of the Tax Information Network in the mid-2000s proved to be most significant.

It might be useful to break the potential for better tax collections from reduced cash holdings into stock and flow effects.

The stock effect includes both the rise in seizures and penalties on undisclosed income (both hard cash as well as bank deposits) that could raise tax collections.

On the other hand, the flow effect comprises an increase in transaction flow through the formal channel that can be, with the right changes in the tax apparatus, captured in the tax net.

Further, in a more trivial statistical sense the tax-GDP ratio is sensitive to the nominal GDP growth, which we expect to be lower than the average of the last three years (10.9 per cent) for both 2016-17 and 2017-18. The lower denominator will also statistically push up the tax-GDP ratio.

Along with these externalities and the statistical push, the one-time boost from voluntary disclosure schemes (such as Income Disclosure Scheme 2016 and Pradhan Mantri Garib Kalyan Yojana) could raise the tax-GDP (Centre) ratio by 1.2 percentage points cumulatively over 2016-17 and 2017-18.

In 2016-17 alone, we expect the tax-GDP ratio to rise by half a percentage point from the previous 10.8 per cent to 11.3 per cent.

Currently, the focus is on unearthing stocks of currency or cash.

The second round of gains will come in 2017-18 when there is closer scrutiny of cash deposited in banks (one must remember that simply depositing untaxed cash has not resulted in laundering from black money to white).

There will also be spillovers from income disclosure schemes announced in 2016-18.

However, the flow effect is likely to dominate next year with rising digitisation broadening the tax base and improving tax efficiency.

Therefore, accounting for these factors, the tax-GDP ratio is likely to rise by 0.7 per percentage points in 2017-18 going by our estimates.

However, in the event that the goods and services tax (GST) is implemented by the second half of next fiscal the tax-GDP ratio is likely to experience an initial drag.

While there is no doubt that tax buoyancy will increase in the medium term after the GST is rolled out in the medium run, there is a fair degree of agreement among economists that the new tax regime may cause temporary disruptions in the tax machinery and, therefore, may lead to slower revenue growth in the initial years of implementation.

This could, somewhat ironically, pare down the potential rise in the tax-GDP ratio.

Past trends show that major tax changes that were aimed at reducing cascading effects in the economy resulted in a decline in the tax-GDP in the short run.

For example, the introduction of Central Value Added Tax in the early 2000s led to a decline of 80bps in the tax-GDP ratio.

To take another instance, the value added tax (VAT) to state GDP ratio declined after the state VAT implementation: Kerala and Odisha saw a fall in 2005 as did Gujarat in 2006.

In case of state VAT, it was also observed that the provision of 100 per cent compensation by the government to states (as is the case with GST) might have resulted in slack revenue collection effort by some of the states.

There is of course the niggling question of whether the GST will be implemented in 2017. In the happy event that is implemented in the second half of the coming fiscal year, it could pull the improvement in the tax GDP ratio from 0.7 per cent to 0.4 per cent.

The combination of reduced cash intensity, a focused strategy of tax administration (without spooking companies and individuals with the spectre of “tax terrorism”) and GST holds the promise of giving the much needed long-term boost to India’s tax base.

However, all three elements will have to be in place for the right result.

Sakshi Gupta, Tanvi Garg and Abheek Barua are economists with HDFC Bank. Views are personal.