The Hindu Business Line : How has the tax-GDP ratio gone up

The increase in Central Government tax revenues has been described as a victory for the Laffer curve in India. In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh examine the real reasons behind the recent increas e in the tax-GDP ratio, in particular the change in income distribution and higher profitability of companies.

The major positive feature of the recently announced fiscal measures is the evidence of increased Central Government tax revenues (Chart 1) and an increase in the tax-GDP ratio. For the Centre, the gross tax-GDP ratio, after rising from 9.2 per cent in 2003-04 to 9.8 per cent in 2004-05, has increased further to 10.5 per cent in 2005-06 (RE), and is estimated to go up to 11.2 per cent in 2006-07.

Coming after more than 15 years of decline, this is clearly a positive sign. It is even more noteworthy because, as part of the process of import liberalisation, the Government has been reducing peak and weighted-average import tariffs.

STRUCTURAL SHIFT

If the Budget Speech 2006-07 is to be believed, this has happened because there has been a structural shift in the Central Government's ability to mobilise resources. According to the Finance Minister, Mr P. Chidambaram, "The strategy of enhanced revenue mobilisation through reasonable rates, better compliance and widening of the tax base is yielding tangible results."

Mr Chidambaram has identified three sources for this tax buoyancy: A regime of reasonable rates of taxation, improved tax administration and a widening of the tax base. The first of these, reflecting the view that moderate rates make people more willing to pay taxes resulting in improved tax buoyancy, is a mere statement of belief with no logical basis. It underlies the infamous "Laffer curve" argument, which has been shown to be empirically unjustified in many contexts.

Further, while the tax administration may have improved, persisting arrears indicate that this has not gone far enough. It cannot be an explanation for the kind of buoyancy that has been recorded.

To assess which factors are adequate explanations of tax buoyancy and gauge their relative roles it is best to turn to the available evidence. Between 2004-05 and 2005-06, the gross tax revenues of the Centre rose by a little more than Rs 65,000 crore or by 21.4 per cent. With real (inflation adjusted) growth in GDP placed at around 7.5 per cent in that year and prices having risen by 4-5 per cent, this increase in tax collections is well above the increase in nominal GDP.

NOT ALL BUOYANT

But not all the principal sources of revenue have been characterised by such buoyancy. A breakdown of the increase (Chart 2) indicates that close to a third of this increase was on account of corporation taxes, which rose by 25.3 per cent, a little more than a quarter was on account of income taxes (characterised by a 26 per cent rise) and around a fifth on account of excise duties (20 per cent). Increases in other significant taxes such as the service tax (13.5 per cent) and Customs duties (10.1 per cent) were more or less in line with the increase in GDP.

The relative lack of buoyancy of service tax is surprising, since a feature of Indian economic growth during the 1990s has been a much faster growth in services as compared with the commodity producing sectors like agriculture and manufacturing. Recognising that the coverage is not enough, or that the net has not been widened enough, the Finance Minister has made an effort, however limited, to extend the reach of the service tax.

The relatively poor performance on the Customs duties front is also intriguing for two reasons. To start with, the high and rising level of oil prices should have helped mobilise additional revenues from these taxes. Further, non-oil imports have been buoyant, because of the rise in GDP. If despite these developments Customs duty collections have failed to keep pace with GDP, the lesson to take home is that tariff reductions associated with trade liberalisation have diluted the role of Customs duties as a revenue-generating device. Thus, if the buoyancy in tax revenues has to be explained we have to understand why, despite moderate tax rates, increases in corporation and income taxes in particular, and excise duties to a lesser extent, have been larger than warranted by the increase in aggregate GDP.

In the circumstance, there appears to be only one explanation.

INCOME INEQUALITY

Growing inequality in the distribution of income between the corporate and non-corporate sectors and between richer and poorer individuals has shifted income in favour of the higher tax bracket. If this is occurring, even for a given level of compliance, tax revenues from these sources should rise faster than aggregate GDP.

One indication that this could have played a role comes from recent evidence on corporate profitability. The net profit of the top 20 companies according to market capitalisation rose by a dizzying 46.5 per cent during the four quarters ending September 2005 when compared with the corresponding period of the previous year. This trend has since continued. This would make the buoyancy in corporation taxes woefully inadequate relative to profit movements.

This trend in Corporate India has been accompanied by a similar movement in corporate and private sector salaries resulting in substantial increases in inter-personal income inequalities. It is this which appears to have delivered more taxes than warranted by the trend in aggregate GDP, but perhaps still not enough.

What this means is that if this increase in tax-GDP ratio is to mark a real turning point and be sustained into the future, it will be essential to tax the rich more, for example by reinstating capital gains tax.