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Themes > Features
07.03.2006

Taxation and the Budget
C.P. Chandrasekhar and Jayati Ghosh

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.

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.

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.

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.
 
© MACROSCAN 2006