There have been major changes in tax systems in several countries over the last two decades for a variety of reasons. The objective of the paper is to describe and assesses the introduction of
new forms of direct and indirect taxes, and their revenue and the successes achieved in their implementation. The paper concludes that after the periods of reform improving the tax system remains a major challenge in India. The
philosophy of tax reform has undergone significant changes over the years in keeping with the changing perception of the role of the state. With the change in the development strategy in favour of market determined resource
allocation, the traditional approach of raising revenues to finance a large public sector without much regard to economic effects has been given up. The recent approaches to reform lay emphasis on minimizing distortions in tax
policy to keep the economy competitive. Minimizing distortions implies reducing the marginal rates of both direct and indirect taxes. This also calls for reducing differentiation in tax rates to reduce unintended distortions in
relative prices. To achieve this, the approach suggests broadening of the tax bases. Thus, over the years, emphasis has shifted from vertical equity in which both direct and indirect taxes are subject to high marginal rates with
minute differentiation in rates, to horizontal equity in which, the taxes are broad-based, simple and transparent, and subject to low and less differentiated rates. Equity in general, is taken to mean improving the living
conditions of the poor. This has to be achieved mainly through expenditure policy and human resource development rather than reducing the incomes of the rich as was envisaged in the 1950s and 1960s.
TRC, VAT, GST, Personal Income, Horizontal equity, Direct & Indirect Taxes
Conventional wisdom on tax reforms provides us three different model of tax reform:
The Optimal Tax (OT) Model
is satisfactory in terms of its theoretical soundness, but has been found to be impractical in its applications. Besides the trade-off between efficiency and equity in tax policy, the information and administrative costs of designing an optimal tax model have been found to be prohibitive and, therefore, as a practical guide to tax policy this has not been useful.
The Harberger Tax Model (HT)
like the OT model is well grounded in theory. It, however, draws much more on practical experience. According to this, while efficiency (and distribution weights) is clearly desirable in the design of tax policy, administrative capability is equally, if not more, important. The principal concern, according to this approach, is not to design a system that will be optimal, but emphasize the system that will minimize tax-induced distortions and at the same time be administratively feasible and politically acceptable. In fact, Harberger suggests that tax reformers should pay less attention to the economic methodology and more to best practice experiences. The basic HT reform package for developing countries that are price takers in the international market consists of,
inter alia, a uniform tariff and a broad-based VAT (value-added tax).
Supply-Side Tax Model (SST) this model emphasizes the need to reduce the role of the state. Reduction in the volume of public expenditures
has to be achieved by cutting the tax rates, particularly the direct tax rates to minimize disincentives on work, saving and investment. The proponents of this model emphasize the need to broaden the base with minimal exemptions
and preferences and to have low marginal tax rates. Again emphasis is on minimizing distortions in relative prices and, therefore, the approach emphasizes less rate differentiation.
The recent reform approaches combine
elements of all three models sketched above. This incorporates both theory and past reform experiences and takes into account administrative, political and information constraints in designing and implementing reforms. The thrust
of this approach is to enhance the revenue productivity of the tax system while minimizing relative price distortions. The best practice approach has attempted to make the tax systems comprehensive, simple and transparent. As
mentioned earlier, the general pattern of these reforms has been to broaden the base of taxes, reduce the tax rates and lower the rate differentiation both in direct and indirect taxes. A broader base requires lower rates to be
levied to generate a given amount of revenues. Lower marginal rates not only reduce disincentives to work, save and invest, but also help to improve tax compliance. More importantly, broadening the tax base helps to ensure
horizontal equity, is desirable from the political economy point of view as it reduces the influence of special interest groups on tax policy, and reduces administrative costs.
In the case of indirect taxation, the reform
agenda includes the levy of a broad-based VAT with minimal exemptions and supplemented by a few luxury excises. As regards import duties, quantitative restrictions should be replaced by tariffs, export taxes eliminated, and
dispersion in tariffs should be minimized. Personal income tax too is to be levied on all but a small number of persons with income levels less than twice the per capita income of the country. Much of the direct taxes should be
collected by withholding, but for the "hard-to-tax" groups, presumptive taxation is to be applied. Emphasis on horizontal equity also implies emphasis on strengthening administration and enforcement of the tax and the development
of proper information systems and automation.
IMPACT OF TAX REFORMS SINCE 1991
Report of the Tax Reform Committee (TRC)
Tax reform since 1991 was initiated as a part of the structural reform
process, following the economic crisis of 1991. In keeping with the best practice approaches, the TRC adopted an approach of combining economic principles with conventional wisdom in recommending comprehensive tax system reforms.
There are three parts in the report. In the first interim report, the Committee set out the guiding principles of tax reform and applied them to important taxes namely, taxes on income and wealth, tariffs and taxes on domestic
consumption. The first part of the final report was concerned mainly with the much-neglected aspect of reforms in administration and enforcement of both direct and indirect taxes. The second part of the report dealt with
restructuring the tariff structure. In keeping with the structural adjustment of the economy, the basic principles taken in the recommendations were to broaden the base, lower marginal tax rates, reduce rate differentiation, and
undertake measures to make the administration and enforcement of the tax system more effective.
The reforms were to be calibrated to bring about revenue neutrality in the short term and to enhance revenue productivity of the
tax system in the medium and long term. The overall thrust of the TRC was to:
* Decrease the share of trade taxes in total tax revenue.
* Increase the share of domestic consumption taxes by transforming the domestic excises into VAT and
* Increase the relative contribution of direct taxes.
The important proposals put forward by the TRC included
reduction in the rates of all major taxes, viz. customs, individual and corporate income taxes and excises to reasonable levels, maintain progressivity but not such as to induce evasion. The TRC recommended a number of measures to
broaden the base of all taxes by minimizing exemptions and concessions, drastic simplification of laws and procedures, building a proper information system and computerization of tax returns, and a thorough revamping modernization
of the administrative and enforcement machinery. It also recommended that the taxes on domestic production should be fully converted into a value added tax, and this should be extended to the wholesale level in agreement with the
states, with additional revenues beyond the post-manufacturing stage passed on to the state governments.
In the case of customs, the TRC recommendations were the weakest. The TRC recommended tariff rates of 5, 10, 15, 20,
25, 30 and 50 to be achieved by1997-98. The tariff rate was to vary directly with the stage of processing of commodities, and among final consumer goods, with the income elasticity of demand (higher rates on luxuries). Excessive
rate differentiation (seven rates) and according varying degrees of protection depending on the stage of processing has been severely criticized by Joshi and Little when they state, "….this is a totally unprincipled
principle, for it has no foundation in economic principles". In addition to continued complexity, the proposed tariff structure creates very high differences in effective rates and provides a higher degree of protection to
inessential commodities. The TRC recommendation also falls much short of developing a coordinated domestic trade tax system in the country. This, in a sense, is understandable, as it had no mandate to go into the state level taxes.
However, the Committee was aware of the serious problems of avoidance and evasion in respect of sales taxes levied by the states predominantly at the manufacturing stage. Therefore, it did recommend the extension of the central VAT
to the wholesale stage with the revenues from the extended levy assigned to the states.
Revenue implications of reforms
The economic crisis of 1991 resulted in a significant decline in revenues. Although
the tax reforms were intended to be a revenue neutral exercise, the natural consequence of a significant decline in tax rates was to reduce revenues. As there was no commensurate increase in the tax base, the revenue naturally
showed a declining trend. Thus, the tax-GDP ratio, which was over 16 per cent in 1990-91, declined sharply to less than 14 per cent in 1993-94. Although thereafter there has been some improvement, it still remains less than 15 per
cent and this remains a matter for concern. Thus, the reforms in the Indian context have in fact, caused an immediate loss of revenues, though in the next few years, they are likely to reach pre-reform levels.
in spite of significant reductions in the rates of both individual and corporate income taxes, the revenues have shown a significant increase. The share of revenue from direct taxes showed a significant increase as a proportion of
GDP as well as total tax revenue. The contribution of revenue from direct taxes, which was less than 14 per cent in 1990-91, increased sharply to 24 per cent in 1997-98. However, it is not clear to what extent the increase in
revenue productivity is due to increase in public sector wages following the implementation of pay commission recommendations, how much of this is attributable to better compliance arising from lower marginal tax rates and how much
due to administrative measures. There is also a commodity tax at the local level called "octroi". This is a tax on the entry of goods into a local area for consumption, use or sale. This tax is levied by urban local bodies and is
levied in many states.
The decline in the tax-GDP ratio since the reforms were initiated has to be attributed to lower yield of indirect taxes. Naturally, some reduction in customs revenue was only to be expected as the
prevailing tariffs were extremely high and had to be drastically reduced. For the same reason, the reforms in excise duties were to be calibrated to compensate revenue loss from import duties. This, however, did not happen and in
fact, the revenue from union excise duties showed a drastic decline. Analysis shows that the revenue from import duties as a ratio of GDP declined by 1.3 percentage points from 3.9 per cent in 1990-91 to 2.6 per cent in 1997-98.
However, decline in the revenue from excise duties was faster, by 1.5 percentage points from 4.6 per cent to 3.1 per cent during the same period. Consequently, the share of excise duties in total revenue declined by about 7
percentage points (from 28 to 21 per cent) as compared to a 6 percentage point decline in the share of customs (from 24 to 18 per cent). Significant improvements in the tax ratio, therefore, have to come from improvement in the
revenue productivity of domestic indirect taxes.
The continued heavy reliance on import duties as a source of revenue rather than as an instrument of protection is an issue that merits some discussion. It has been pointed
out that the central government does not have the incentive to raise revenues from the taxes that are shared with the states.
Shortcomings & Challenges
After eight years of tax reform, as already
mentioned, a number of disquieting features in the tax system still remain. Improving the productivity of the tax system continues to be a major challenge in India. The tax ratio is yet to reach the pre-reform levels. Although the
coverage under income tax has shown significant improvement, much remains to be done to reach the hard-to-tax groups. The ratio of domestic trade taxes in particular has continued to decline and this has posed a major constraint in
reducing tariffs which is necessary to achieve a locative efficiency. Designing of tariffs itself needs to be re-examined to ensure lower tariffs a well as a low level of dispersion to ensure that effective rates of protection are
as intended. Reforms in excise duties have not reached the stage of achieving a simple and transparent manufacturing stage VAT. Much remains to be done to simplify and rationalize the state and local consumption taxes. Concerted
efforts are necessary to create a proper management information system and automating tax returns. Above all, tax reforms should become systemic, a continuous process to keep the economy competitive instead of being sporadic and
In the case of direct taxes, as already mentioned, the revenue ratio has shown an upward trend. Marked decline in tax rates seems to have improved tax compliance, though much of the increase seems to have come
about due to increases in public sector wages. Yet, the revenues realized are nowhere near the potential and much remains to be done to improve the horizontal equity of the tax system by extending the tax net to hard-to-tax groups.
The criteria stipulated for filing tax returns has increased the number of tax returns from less than half a per cent of population to more than 2 per cent. But this has not brought about a corresponding increase in revenues.
Inability to bring in the hard-to-tax groups into the net has continued to exert pressure to increase the standard exemption limit deductions. There is also scope for rationalizing savings incentives.
In the case of
corporate income taxes, too, it is necessary to broaden the tax base by minimizing tax concessions and preferences. Rather than minimizing them, the recent coalition governments have gone about proliferating tax incentives to
complicate the tax system and to create a wide wedge between the nominal and effective corporate tax rates. As the companies started using the provisions, for revenue reasons, the government started levying the minimum alternative
tax (MAT). Thus one imperfection was sought to be remedied through another. This has complicated the tax system further. A complete rethinking is necessary in designing tariffs. The TRC recommendation of having seven tax rate
categories, the rates varying according to the stage of production, would create large dispersal in the effective rate of protection. Levying lower rates on necessities and higher rates on consumer durable and luxury items of
consumption enormously increases protection to these products.
It is essential that the highest tariff rate should be brought down to 15-20 per cent and there should be no more than three rate categories. Unless this is
done, it would not be possible for Indian manufacturing to achieve international competitiveness in the medium term. The most important challenge in restructuring the tax system in the country is to evolve a coordinated consumption
tax system. Although tax assignment between different levels of government follows the principle of separation, as these separate taxes levied by the centre (excise duties), states (sales taxes, state excise duties, taxes on motor
vehicles, goods and passengers), and local governments (octroi) fall on the same tax base, we end up in a chaotic situation with tax on tax and mark up on the tax. Besides cascading and relative price distortions, this results in a
totally non-transparent tax system. Development of dual VAT – a manufacturing stage VAT by the centre and a consumption type destination based retailed stage VAT by the states is a solution, which needs to be progressively applied.
However, neither the centre nor the states have made appreciable progress in this regard. To achieve this, in the case of the centre, the excise duties should be levied entirely as ad valorem levies.
The rates should be rationalized into a maximum of two and tax credit should be provided on a systematic basis. For this, developing a proper information system is imperative. At the state level, transforming the state taxes into VAT has to be calibrated even more carefully. Rate rationalization, systematic provision of tax credit on inputs and those paid on previous stages, removal of competing tax incentives and concessions, zero rating the tax on inter-state sales – all these have to be done in phases.
A major difficulty in evolving a destination based retail stage VAT at the state level arises from the fact that the states do not have the power to levy tax on services. As mentioned earlier, the states can levy sales
taxation of only goods. Taxation of services is not assigned to either the centre or the state, but the former levies taxes on selected services based on power to levy taxes on residual items. Proper levy of goods and services tax
would, therefore, require an amendment of the Constitution. The central government can use this as a leverage to persuade the states to reduce and eventually eliminate the taxation on inter-state sales so that a levy of destination
based VAT becomes a reality.
VAT was not extended to sales tax, as sales tax is under the jurisdiction of state government. However the state government have agreed to introduce Sales Tax VAT
& introduced from April2005. Haryana Government has introduced Sales Tax VAT in April2004 & Reported the experience is to be good. The Kelkar Committee in the chairmanship of Shri. Vijay Kelkar submitted its report in
July2004 & strongly recommended Goods & Services Tax – GST.
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