Budget 2001-02

Will the surcharge go?

By Ila Patnaik

Soon after the earthquake, the finance minister announced a surcharge on income tax. Which he did with great speed. Even before estimates of the losses or of budgetary support to the relief programme could be made.

But then, this is perhaps nothing new for Mr. Sinha. He is likely to be remembered more for his unplanned, supposedly temporary surcharges, than for his visionary plans for the economy. 

Because if he had plans for reviving growth in the economy, he would perhaps have spent a lot more time, thinking about its implications before imposing any fresh taxes. In fact, as I argue below, there are many good reasons for not imposing the surcharge at all.

The first and most obvious reason for not imposing additional taxes is simple accounting. Till December 2000 the government had spent only 60 per cent of the budgeted expenditure. There was thus considerable scope for higher expenditure by the central government without raising revenue. Especially since a large share of the unspent amount was budgeted to be capital expenditure. A lot of it in all likelihood may not be spent at all.

But of course, that would have meant a higher tax collection effort. Because revenues collected are also only 65 per cent of the budget targets. But if revenue targets could be met, even if not entirely, there was no need for additional taxes at all.

The  second reason why fresh taxes should not have been imposed is  basic principles of taxation. One aspect to consider is that as tax rates are pushed higher and higher, compliance may reduce and the tax collected actually decline. The classic Laffer curve. That is one reason why Mr. Chidambaram had reduced tax rates. Mr. Sinha, who has been reversing the progress he had made on this front, should reconsider his policy of raising rates.

Even if the Laffer curve does not hold in India, there is a question of credibility. The 10 per cent surcharge on income tax that was imposed 2 years ago was meant to be temporary. As his temporary surcharges acquire a more and more permanent character, Mr. Sinha looses credibility that his surcharges are actually temporary. He has effectively raised tax rates on both personal and corporate income by more than 7-8 per cent already during his tenure.

Further, is the issue of horizontal equity. When in a country of a billion  only about 20 million people pay income tax, there is a strong case for widening the tax base, rather than collecting more from those who are already tax-payers. While it is true that it might be administratively more difficult and politically less popular to bring into the tax net those who are not paying taxes, the circumstances could have provided an opportunity to take more difficult decisions.

The third and most important reason why taxes should not be raised in the current economic situation is the role of fiscal policy. There is a case for an expansionary fiscal policy when aggregate demand is slack. Raising taxes to curtail the deficit could be recessionary. Currently slackening aggregate demand is visible from a number of things.

First, it is clear from the low core inflation rate, defined as price rise excluding prices of fuel and energy. This suggests that supplies are comfortable. Even the oil price hike did not push prices of manufactured products up through a cascading effect. Also, the significant shortfall in agricultural production did not push food prices up. So, inflation in manufactured and food products remains between 3 to 4 per cent. There is scope for demand to increase without necessarily pulling up prices.

Second, the current account deficit is low. Imports are not rising. And indeed, while petroleum imports are higher in value terms compared to last year, non-oil imports have actually declined by 3.1 per cent this year. Demand for both imported end products and intermediates is low, as is demand for domestically produced goods. Thus, rather than substitution of domestically produced goods by imported goods, or imports being responsible for the slowdown in domestic industrial growth, it is overall demand that is low.

Third, the low level of demand is reflected in the low investment being undertaken in the economy. Low investment indicates that both the current and expected level of demand in the economy is perceived to be low. This is revealed in the falling levels of capital goods production and declining imports of machinery and equipment.

There is, therefore, every reason to believe that the economy is suffering from a slowdown in aggregate demand. In such circumstances it is possible to raise growth by increasing expenditure without pushing up the inflation rate as the economy has excess capacity. So at this juncture instead of raising the tax rate, expenditure for the earthquake hit state could have been financed even by a deficit, if not be collecting taxes from those who are currently non-tax payers.

And finally, a good reason not to have imposed another surcharge is one of signals and psychology. Remember business confidence has been falling continuously throughout the year. Public investment cannot be increased easily as it has not implications not just for current expenditure but also for future spending. The Reserve Bank is not keen on cutting interest rates significantly because it worries about the margins of banks. How, then, can investment be revived?

There could have been a ray of hope in policies that improve sentiment without striking a major dent on long term finances of the government. In the coming budget this might have been achieved to some extent by removing the 'temporary' surcharge on income tax. In fact, calculations suggest that if the amount retained by the corporate sector on account of this tax relief was to be invested by them, the consequent increase in production would be greater than the increase in fiscal deficit. This would actually pull down the fiscal deficit to GDP ratio.

Before the Gujrat surcharge was imposed, there were hopes of the previous surcharge of 10 per cent being removed. Now that possibility seems remote. It appears more than ever that Mr. Sinha has used the moment to cash in on public sentiment to improve government finances than consider reviving the economy.

It might be that the next budget retains not only the earlier surcharge but the earthquake surcharge as well. If it does, it would show not only that the finance minister is not very sincere about improving revenue collection on a long run basis, it would also show that he does not give adequate priority to reviving investment. Since he himself has very little leeway to increase public investment to improve growth, this may prove to be highly costly to the economy.

But can one hope the budget will bring a relief from surcharges? With Mr. Sinha at the helm of affairs? I think not. But I hope I will be proved wrong. 


Ila Patnaik