Tax buoyancy: Devil in the details

In recent times, direct tax buoyancy has increased

The Kelkar Task Force report seems set to ease the common man’s burden in an innovative way in order to meet FRBM targets. The “Dream Report” suggests that cutting tax rates — while simultaneously removing exemptions and loopholes — will lead to a reduction in the government’s revenue deficits.

Such a win-win solution seems too good to be true. While economics textbooks talk about the Laffer Curve (where cutting rates can sometimes give higher tax revenues as there is less incentive to avoid taxes) it is sometimes claimed that this idea has been tried in India and failed.

Tax rates have been lowered in India and tax revenues came down.

In 1987-88, the Centre’s tax collections were 10.6 per cent of GDP. In 1993-94 — after massive cuts in all kinds of rates — they had dropped to 8.8 per cent of GDP. By 1998-99, they had fallen further to 8.3 per cent of GDP. Where then is the fabled “tax buoyancy”, the increase in taxes that comes with an increase in GDP?

The devil lies in the details. Tunnelling into components of taxation shows a different story.

A lot of tax revenue was lost with the phasing out of customs duties, which has hurt the overall Tax/GDP ratio.

Interestingly, the evidence shows that when GDP goes up by 1 per cent, income tax and corporate tax collections go up by 1.2 per cent (in other words, a “tax buoyancy” of 1.2). Moreover, in recent times, tax buoyancy of direct taxes has increased. In the first year after the reduction in tax rates in Chidambaram’s Dream Budget in 1997, the income tax to GDP ratio fell slightly, but then it recovered and rose sharply in the following years.

This is attributed to an increase in compliance — a classic case of the Laffer Curve in action.

The impact will be more potent if cutting rates is accompanied by removing exemptions — which Chidambaram neglected to do right last time.

A similar scenario is expected if one sees Kelkar’s projections. Take personal taxes.

Assuming Kelkar’s proposed I-T rates are implemented, along with a removal of most exemptions, a Rs 11,243-crore loss in tax collections is projected for the first year.

It is expected that in the following year 60 per cent of the loss would be recouped due to better compliance, because households would have less incentives (at lower tax rates) to try to dodge taxes.

Ila Patnaik