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Taxation
and the Budget |
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| Mar
7th 2006, C.P. Chandrasekhar and Jayati Ghosh |
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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 increase to 11.2 per
cent in 2006-07.
Chart
1 >>
Coming
after more than fifteen 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.
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: ''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
tax 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 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.
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.
Chart
2 >>
The relative lack of buoyancy of the 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.
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 included in the Economic Times 500 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. |
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Box
1. Capital Gains Tax
Just
before the FII surge began, and influenced perhaps
by the sharp fall in net FII investments in
2002-03, the then Finance Minister declared
in the Budget for 2003-04: ''In order to give
a further fillip to the capital markets, it
is now proposed to exempt all listed equities
that are acquired on or after March 1, 2003,
and sold after the lapse of a year, or more,
from the incidence of capital gains tax. Long
term capital gains tax will, therefore, not
hereafter apply to such transactions. This proposal
should facilitate investment in equities.'' (Ministry
of Finance, Government of India 2002: Paragraph
46).
In the very next year, the Finance Minister
of the UPA government endorsed this move. In
his 2004 budget speech he announced his decision
to ''abolish the tax on long-term capital gains
from securities transactions altogether.'' (Ministry
of Finance, Government of India 2004: Paragraph
111). It is no doubt true that he attempted
to introduce a securities transactions tax of
0.15 per cent to partially neutralise any loss
in revenues. But a post-budget downturn in the
market forced him to reduce the extent of this
tax and curtail its coverage, resulting in a
substantial loss in revenue. Thus, an extravagant
fiscal concession appears to have triggered
the speculative surge in stock markets that
still persists.
The implications of this extravagance can be
assessed with a simple calculation which, even
while unsatisfactory, is illustrative. Let us
consider 28 of the 30 Sensex companies for which
uniform data on daily share prices and trading
volumes are available for the years 2004 and
2005 from the Prowess Database of the Centre
for Monitoring the Indian Economy. (In one case
(Larsen & Toubro), data on trading volumes
were not available in Prowess for 25 out of
254 trading days in 2004). For those days, we
use the annual average trading volume as a proxy.)
Long term capital gains were defined for taxation
purposes as gains made on those assets held
by the purchaser for at least 365 days. These
gains were earlier being taxed at the rate of
10 per cent.
Assume now that all shares of these 28 Sensex
companies bought on each trading day in 2004
were sold after 366 days or the immediately
following trading day in 2005. Multiplying the
increase in prices of the shares concerned over
these 366 days by the assumed number of shares
sold for each day in 2005, we estimate the total
capital gains that could have been garnered
in 2005 at Rs. 78,569 crore.
If these gains had been taxed at the rate of
10 per cent prevalent earlier, the revenue yielded
would have amounted to Rs. 7,857. That reflects
the revenue foregone by the state and the benefit
accruing to the buyers of these shares. It is
true that not all shares of these companies
bought in 2004 would have been sold a year-and-one-day
later. But some shares which were purchased
prior to 2004 would have been sold during 2005,
presumably with a bigger margin of gain. And
this estimate relates to just 28 companies.
In practice, therefore the estimate provided
is likely to be an underestimate of the total
capital gains from transactions that would have
been subject to the capital gains tax. While
it needs to be noted that the surge in the market
may not have occurred if India had not been
made a capital gains tax haven, the figure does
reflect the kind of gains accruing to financial
investors in the wake of the surge. Once the
FII increase resulting from these factors triggered
a boom in stock prices, expectations of further
price increases took over, and the incentive
to benefit from untaxed capital gains was only
strengthened.
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