India caught in a tax trap that is limiting its growth

·4 min read

As India battles COVID-19, individuals and MSMEs have been severely impacted. They are looking up to the central government to provide a stimulus package to bail them out.

Being a developing economy, India has a significant need for infrastructure creation. As the country is short of capital, 75% of investment in infrastructure has come from the government sector.

The private sector has not been able to contribute significantly. Private investments hit a 16-year low in 2019.

It means the central government has to do a lot of heavy lifting, spending money on social welfare projects and creating project assets.

However, the resources of the government are limited. The earnings include direct taxes (income taxes from corporates and individuals) and indirect taxes (excise/customs duty and GST). Non-tax revenues include dividends from RBI and PSUs, disinvestment proceeds, and interest on loans granted.

The total tax collections are not sufficient to meet the expenditure commitments and the government has to resort to borrowings to finance them.

For example, in the financial year (FY) 2019-20, the tax collections/revenue receipts were Rs 16.8 lakh crore, whereas revenue expenditure was Rs 23.5 lakh crore, resulting in a revenue deficit of Rs 6.7 lakh crore.

There was no money for meeting capital expenditure requirements of Rs 3.3 lakh crore. The deficit was financed through borrowings of Rs 9.3 lakh crore.

Borrowings act as a double whammy as they carry interest obligations. Interest on such borrowings accounts for 20%-25% of the revenue expenditure. In FY 2019-20, such expenses were Rs 6.1 lakh crore.

Our tax collections are not growing at the desired pace resulting in a low tax to GDP ratio. India's tax-GDP ratio plunged to 9.88% in FY 2019-20, the lowest in 10 years compared to the OECD average of 30%+.

Source: Union Budget, Income Tax Database

“Low tax to GDP ratio makes it difficult for the government to provide sufficient funds for investment and infrastructure expansion while staying within the bounds of fiscal prudence,” according to the Economic Survey 2020-21.

Our direct tax collections declined in FY 2019-20 (-8%), which had a limited COVID-19 impact. Naturally, it plunged further in FY 2020-21.

Two decisions of the central government led to this situation:

(i) a reduction in the corporate tax rate for domestic companies from 30% to 22% if they do not seek any exemption or incentives

(ii) a rebate of Rs 12,500 in personal income tax, effectively doubling the limit of income exempt from tax to Rs 5 lakh p.a. (benefitting three crore individuals)

It effectively cost the government Rs 1.7 lakh crore in FY 2019-20.

We all know that only a small percentage of the population pays taxes. As per data available, 5.91 crore individuals filed tax returns for FY 2019-20. On average, 40% of people file zero income tax returns, meaning only 3.5 crore individuals paid tax.

However, in the last five years, more than 1.5 crore cars have been sold in the country. Over 3 crore Indians went abroad for work or travel.

There are 27.5 crore households in India. Approximately 16 crore households are either agriculturists and/or belong to below the poverty line. Income from agriculture is not taxed in India.

This shows that only 30% of individuals / households eligible are currently paying taxes, others evading.

Source: NIPFP Working Paper titled “The Economy as Reflected in Income Tax Data”

Of companies registered, only around 70% file income tax returns. Here as well 44%-45% of companies file zero income tax returns.

This shows that only 40% of companies registered are currently paying taxes, others evading or not earning profits. If the latter is true, then it highlights significant inefficiencies in our corporate system, which is not sustainable.

Low Tax to GDP ratio is also an indicator of our poor tax compliance.

Late finance minister Arun Jaitley, highlighting this fact, had once quipped, “Despite higher compliances in the new system, as far as non-oil taxes are concerned, we are still far from being a tax-compliant society. Salaried employees are one category of tax compliant assessees.”

He added that most other sections would have to improve their track record.

There are only two ways to increase direct tax revenues, by increasing the tax base or by increasing the tax rates, or by a combination of the above.

Our direct tax to the indirect tax collection is also skewed at 50:50 compared to the OECD average of 67:33. It also highlights that our income tax collections need to increase from current levels.

One more interesting thing which has happened last year is that personal tax collections now exceed corporate tax receipts.

Over the years, we have failed to broaden the tax net, in fact we have been excluding people from the base.

Taxing rich farmers, rationalizing existing rates (higher rates for high-income individuals), and enhanced compliance seem to be the only way out. Else, we will never be able to come out of this tax trap and realise the true potential of our economy.


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