Indian Tax system �?? Present, Ideal vs Optimal

Indian Tax system is presently classified under two heads – Direct and indirect. Direct tax includes Income tax, corporate tax, Securities Transaction Tax (STT), Wealth Tax and Capital Gains tax. There are other subdivisions like withholding tax, Minimum Alternate tax, Dividend distribution tax on the direct side whereas Indirect taxes basically include Excise duty, customs duty, Service tax, central sales tax and value added tax.

With so many taxes to manage, there are currently tax disputes involving Vodafone, Sistema, etc who are threatening to go for international arbitration. Attracting greater investment comes with the responsibility of treating foreign investors equitably, as also a risk of external scrutiny of state actions. Indeed, the media attention surrounding the Vodafone saga, coupled with the amount at stake, has transformed the political landscape as well.

In this context we need to look into the present system, have an eye on ideal system and try to march towards an optimal and workable system.

Let us see how the present Indian tax system fares in PWC Paying Taxes report, which is as follows -

	2007	2009	2013	2014
Total Tax Payments in India	59	60	33	33
Time to Comply (hrs)	264	271	243	243
Total Tax Rate (as a % of profits)	71.5	71.5	61.8	62.8
Overall Ranking	NA	169	152	158

Now let us see how India fares when we compare with other BRIC Nations, our neighboring countries and an Arab state

Overall Ranking	2009	2013	2014
Brazil	145	156	159
Russia	134	56	56
SouthAfrica	23	32	24
China	132	122	120
Bhutan	82	71	104
Srilanka	164	169	171
Bangladesh	90	97	100
Pakistan	124	166	166
United Arab Emirates	4	1	1

Though we find that India has done quite well among emerging nations but the Economies like china and Russia have done better, especially Russian tax reforms and UAE tax structure can offer lot of food for thought for India. Asia Pacific average total tax rate (as a percentage of profit), time to comply and number of payments are 36.4%, 232 hrs and 25.4 respectively compared to India’s 62.8%, 243hrs and 33. Thus India has a long way to go.

An ideal tax system would be something which is a kind of best practice, established once and for all, without any change over time. Debates are on between two group of thinkers, one a proponent of progressive tax structure (as we have in India) and another who thinks that a flat tax rate is better. Advocates of progressive taxation usually start with the notion of social justice. They want justice in the tax system based on the principle of equality or balancing of living conditions. They claim that it is much more appropriate to take away from those who have higher incomes and distribute it in order to balance living conditions. Flat tax rates are based on principles of Horizontal justice (tax everyone) while progressive tax structures are based upon principles of vertical justice (tax the wealthy more). Countries following flat tax structures have higher growth rate compared to countries with progressive tax structures. However, the later has far less income inequality than the former does. Therefore, the debate on ideal tax structure is going to continue in near future.

Optimal tax system is different from one country to another and even within the same country from one year to the next. It actually depends on the value systems of the society, and whether the tax system meets the expectations of the society or not. Best tax system is probably the one which shows the highest level of compliance on the part of the society. If the people are happy with that, or at least comply with the rules and pay their dues, it is probably acceptable, if not an optimal system.

The second point I want to make is that a tax system should be obviously quite simple for the whole society to understand. The most important objective is of course to generate sufficient amount of public revenue in order to pay for public goods and services. In order to be effective, a tax system should be predictable, understandable, calculable, stable, and as a consequence, easy to comply with.

Third point that I will like to stress on is that an optimal tax system demands that taxation should not be used to channelize Social policy objectives. Once you start offering benefits to certain sections of society (like exemption of agricultural income even though tracing billionaire farmers in Punjab and few other states is not uncommon), then taxation system becomes like potholed roads.

Fourth point that I would like to say is that optimal system should not be such that it allows more and more deductions to persons who earn more. In India we often find higher rank executives and owners of large corporate houses employ quite a few employees for their personal works though their salary is often paid from company accounts. This is effectively a hit on corporate governance as it reduces the profits of company and benefits a particular section of shareholder often at the cost of ungrouped majority shareholders, who otherwise should have got a justified return on a pro-rata basis by way of dividends. This is a hit to the government too as it earns less corporate tax and lesser dividend distribution tax, a hit to investor community at large, as they miss better return on investment. There are various other ways by which deductions can be made possible as the system allows it.

Fifth point that I will like to make is that the tax system can not be separated from the structure of public administration. Optimal tax system can’t exist without taking into consideration which level of government gets the revenue, and how that revenue can be spent on the other side of profit and loss account of the level of government we are talking about. A point to note is the recent spat between GOI and Govt of West Bengal. Central govt gets the bulk of its revenue from Bengal’s bucket while returns for development & administration of Bengal are not up to the justified levels.

The last question, which makes the issue even more complex in this regard, is whether we allow local governments to spend these transfers from central government freely on whatever they want. For example the Bengal Govt decided to spend 500 cr funds for victims of Sarada ponzi scheme, distributed 1 lakh – 2 lakh to some 6000 sports club, the then chief minister of UP built Rashtriya Dalit Prerna sthal at a cost of 685 crore, Present CM of UP distributing 1cr each to films shot in UP even when thousands of victims of Muzaffarnagar languish in hunger at temporary shelters.

On the basis of the above, it is time that we think seriously about a single tax regime satisfying most of the optimal tax structure essentials. Therefore, I would like to revisit the thoughts of Nicolas Kaldor, the proponent of Expenditure tax. Economics is always not about equilibrium irrespective of state where we are in, and taxation can never be constrained to justify the Keynesian theory of spending that leads to growth.

Every person has right to earn, right to save, right to make profit and all these are in any case adding to GDP of the nation. So the very idea of taxing incomes, savings and profits needs to be revisited. In India approx 2.8% of people pay tax (as per P.Chidambaram’s statement in parliament). Therefore, Expenditure tax can be a solution to India’s woes. Hence, I propose a tax @ 10% (5% goes to central Govt & 5% to local Govt) on any item or services sold in India .This will immediately broaden the tax net and reach persons who have never been taxed before. Thus the principle of horizontal justice will be served and 1^st component of Optimal Tax structure will be satisfied.

Umpteen number of taxes with different rates, amendments to income tax laws after getting defeated in court of law, changing of what will be taxed and what won’t be with change of guards in Govt, etc. can’t be a policy of taxation. We need simple, understandable, viable, stable, calculable and predictable tax policy. Some have proposed a banking transaction tax. It won’t work simply for two reasons, first India’s banking system is still immature and still 80% plus population do not have access to banking and thus a big part of Indian economy is dependent on cash transactions. Second, taxing banking transactions will force public resort to cash economy which will essentially increase black money, lessen savings, increase hoarding of precious stones and metals, ultimately reduce tax received by Govt and worsen India’s Current account deficit problem. Expenditure tax on the other hand will bring into its fold entire cash economy. The price of any item or services will include tax which needs to be deposited by the manufacturer of the product. The liability to deposit tax will be on producer of the product and not purchaser. Unsold products will be given tax credit points that can be set off against future liability, but all manufacturing and services must be reported. An item can be a bottle of water, a car, a pen, a book, a shirt, a saree, a new or old flat or house, a train ticket, a vacation to Darjeeling, petrol from petrol pump, gold you buy, coaching centre classes, agricultural outputs like rice, wheat, soya oil, rubber, etc. This will thus solve 2^nd component of optimal tax structure.

Since it will tax all it will offer benefit of exemption to no section of society. Persons earning more or less will be taxed equally while lower income groups can be separately taken care of by a system of social security. This will take care of 3^rd & 4^th component of optimal tax structure. A 50-50 division of tax between central & local govts will ensure that 5^th component is satisfied.

Of the 5% that each Govt receives 20% must mandatorily be used by each govt for rolling out a comprehensive social security system including sanitation & healthcare, education, rationing, lodging and pension for all. This will ensure that 6^th component is satisfied to a certain extent.

Expenditure tax will help immediately in reducing cost of petrol, disel, train fares, air fares, and will also reduce demand effectively solving the inflation problem that the nation is going through. Giving an example, Petrol prices will drop to Rs. 60.5/ltr since landed cost of petrol at $119/barrel is Rs 46.4 while processed cost of petrol including transportation is Rs 55 and tax will be just Rs. 5.5/ltr instead of approx Rs. 25/ ltr that is being charged currently. This will drive down essential commodity prices and vegetables giving the much needed relief to Indian middle class housewife who is finding it difficult to meet her kitchen expenses and also totally eradicate the huge fuel subsidy bill.

Considering size of Indian economy to be about Rs. 113,71,886 cr (as per budget estimate of 2013-14) and Black economy around Rs. 45,48,754.4 cr ( Mr. Arun Kumar, professor of Economics in Jawaharlal Nehru University pits black economy to be equivalent to 40% of GDP in his book “The Black Economy in India”. As per Friedrich Schneider, average shadow economy size of 90 developing economies is 38.7%) total Indian economy’s size is roughly 159,20,640.4 cr. A tax net covering 60% of total economy @ 10% tax rate gives revenue of 9, 55,238.424 cr against a budgeted amount of 8,84,078 crore. This extra revenue of Rs. 71,160.424 cr will cut Fiscal deficit to Rs.4,71,338.576 cr that is just 4.144% of GDP from Rs. 5,42,499 cr or 4.77% of GDP. It will positively impact profits of companies, banking system will get a new life with CDRs drastically coming down, cost of funds will go down, liquidity conditions will improve and savings will increase leading to overall increase in investment. Thus the economy will shift towards investment induced growth which is much more sustainable and long term than consumption induced growth. It will effectively create more jobs, deliver social security and thus deliver on the principles of Gross National Happiness!

The opinions expressed in this article are those of the author and do not necessarily reflect the views of our organisation.