India’s tax-to-GDP ratio is at 16.6% is well below the emerging market economies (EME) and OECD averages of about 21% and 34% respectively. Taxation is the key to long run political and economic development. According to recent economic survey, it said India needs to increase its tax-GDP ratio, and spend more on health and education.

Comparison with OECD Countries

  1. India's tax to GDP increased from 10.4% in 1965 to 16.6% in 2015-16, the corresponding tax-to-GDP ratio of OECD countries increased from 21% in 1965 to 33% in 2015. 
  2. Even compared to OECD nations with lower GDP (Korea, Turkey, Mexico, Chile, Portugal, Greece, Slovenia and Poland) is still lower at 16.6% versus average of 24% of these nations.
  3. Among the G-20 Countries, India had the third lowest tax-base, just above Mexico and Indonesia. 
  4. A high tax-to-GDP ratio is also a common feature of countries with high level of social security measures such as Belgium, Denmark etc.
  5. The level of tax compliance in most advanced countries is very high, as high as 90%.
What is the Tax-To-GDP Ratio?
The tax-to-GDP ratio is the ratio of tax collected compared to national gross domestic product (GDP). In a simpler language, it would be Tax contribution towards GDP.Some countries aim to increase the tax-to-GDP ratio by a certain percentage to address deficiencies in their budgets. 

In states where tax revenue has gone up significantly in comparison to GDP, policymakers may decide to increase the percentage of tax revenue they apply towards foreign debt or other programs. 

Prelims Question: 2016
A decrease in tax to GDP ratio of a country indicates which of the following?
1. Slowing economic growth rate
2. Less equitable distribution of national income
Select the correct answer using the code given below.
(a) I only
(b) 2 only
(c) Both 1 and 2
(d) Neither I nor 2
Syllabus: Economy, General studies Paper-3 mains and prelims

1.What do you understand by tax-to-gross domestic product (GDP) ratio? Compare India’s tax-to-GDP ratio with that of OECD economies and comment whether India should strive to increase this ratio or not.
2.What is tax-to-GDP ratio? According to the recent Economic Survey, India’s ratio of tax-to-GDP (gross domestic product) is 5.4 percentage points below that of comparable countries. What are the implications of lack of an adequate tax base for India? Analyse.
3.Discuss the concept of tax to GDP ratio. What does a lower tax to GDP ratio indicate? How does it affect a developing economy like India? What reform measures are required to improve it? Discuss.
When tax revenues grow at a slower rate than the GDP of a country, the tax-to-GDP ratio drops; when tax revenue grows faster than GDP, the ratio increases. For example, if a country has a $10 trillion GDP and tax revenue of $2 trillion, its tax-to-GDP ratio is 20%. 

If its GDP increases to $15 trillion and its tax revenue jumps to $3 trillion, it retains its 20% ratio. In contrast, if GDP increases to $18 trillion and taxes only increase to $3 trillion, the ratio falls to 16.7%, and conversely, if tax revenue climbs to $4 trillion and the GDP rises to $12 trillion, the tax-to-GDP ratio grows to 33.3%.

What Does the Tax-to-GDP Ratio Mean?
The tax-to-GDP ratio gives policymakers and analysts a metric that they can use to compare tax receipts from year to year. In most cases, because taxes are related to economic activity, the ratio should stay relatively consistent. Essentially, as the GDP grows, tax revenue should grow as well.

Tax and GDP are related, since a higher GDP will automatically lead to a higher tax collection (a higher GDP is an indicator that there has been an increased overall development in the country and hence a higher per capita income). 

Increasing the country's tax-GDP ratio may become important if its fiscal deficit is high. This is because the higher the fiscal deficit, the more the gap between the revenue the government is generating from tax and other sources such as PSUs, investments, exports etc and the expenditure it is incurring in doling out subsidies, running welfare schemes and running the government. 

To close this gap between income and expenditure, the government needs more revenue, which it can get from tax revenues. However, countries like India have a low tax to GDP ratio. The problem arises especially in countries where development is low and tax evasion is high.

Taxation is the key to long run political and economic development. Therefore bringing more and more people into the tax net via some form of direct taxation will help in increasing the tax-to-GDP ratio as well as government commitment to its developmental programmes.

What are the reasons for India’s low tax-to-GDP ratio?
Following reasons can be attributed to the low tax (both direct and indirect) to GDP ratio in India.

  1. High tax evasions-Tax compliance in India is extremely low.
  2. Low per capita Income: Low average incomes and a high poverty rate result in a very small portion of the labor force being eligible to pay personnel income tax.
  3. Unorganized sector: India has relatively large informal/unorganized sector, and tax evasion is more rampant in informal sector compare to organized sector.
  4. Small Tax Base and its adverse effect tax buoyancy: In India, only 3% people pay income tax. This is because a large population is still poor and hence don't earn enough to be in taxable income bracket, but also because even those who fall under the tax bracket, either don't pay or pay very little taxes. A small tax base unnecessary burdens the honest tax payer. According to Shome Panel, in the last 10 years though the direct tax collection has increased by more than 700%, the number of tax payers has merely grown by 35%.
  5. Lingering of contentious, adversial tax issues:  India has one of highest number of disputes between tax administration and taxpayers, with lowest proportion of recovery of tax arrears. For example: the Vodafone tax dispute involving RS 20 K crore lingering since 2008.
  6. Tax exemption and subsidy policies: The exemptions in the taxable income have grown at a much faster rate than the income. As a result, there is less tax buoyancy. Similarly tax expenditure in the form of tax subsidies and exemptions was more than 6 lakh crore in 2015-16.
  7. Loop-holes in double tax avoidance treaties: Provisions for tax exemptions from short term capital gains are often misused by companies to re-route their investments from such countries (called round tripping of funds). Similarly issues related to tax-evasion, double non-taxation and transfer pricing need to be fixed.
  8. Flourishing informal market ecosystem: informal sectors like paying –guest accommodations, Kirana stores, Stationary shops, etc. Evade taxation.
Measures to Improve Tax-to-GDP ratio: 

  • Widening tax base: This can be done by implementing GST. GST will be a game changer as it will radically improve collection efficiency, will phase out a number of exemptions in a phased manner; lowers tax rates, increase the compliance level and generate more revenues from indirect taxes. GST will widen the tax base and generate additional revenues.
  • Improving compliance rate of tax laws: GAAR (General Anti-avoidance rules) provisions may be useful in dealing with tax evasions where tax benefits exceed certain limit.
  • Efficient targeting of subsidies and phasing out of tax exemptions: subsidies to the well off need to be scaled back, similarly tax exemptions to be reviewed and phased out, reasonable taxation of the better off regardless of where they get their income from like industry, services, real estate or agriculture.
  • Fast racking of disputes: Fast tracking of tax disputes, reducing discretion of taxman and creating a predictable dispute resolution mechanism.
  • There is a need to avoid retrospective taxation.