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Budget 2020: Reform income tax to build fiscal capacity. That pays

Income tax data from four countries – the UK, the US, France and Japan – hold useful lessons for India.

January 30, 2020 / 04:23 PM IST

Sharmadha Srinivasan and Prakhar Misra

When Finance Minister Nirmala Sitharaman presents the Union Budget on February 1, she will have the unenviable task of finessing a grim growth scenario.

A new Reuters report, if it holds true, points to an additional wrinkle. At a time when the government is making noises about following up the recent corporate tax cuts with income tax sops to push demand, direct tax collections this fiscal could dip below last year’s Rs 11.5 lakh-crore. Short-term complications aside, this points to a larger problem: the Centre’s perennial inability to mop up income tax commensurate with its fiscal needs.

The government’s proposal of raising the personal income tax slab rate of 5 per cent from Rs 5 lakh to Rs 7 lakh has more to do with optics than economic logic. It will be a weak stimulus at best, given that only 5.9 crore people, or about 4.5 per cent of the population, pay income tax, according to the Economic Survey 2017-18.

Economists Thomas Piketty and Nancy Qian have drawn a direct link between this sort of constant tinkering with exemption levels and India’s failure to fulfil its long-term imperative of widening the income tax base and strengthening income tax collections — just 2.7 per cent as a percentage of gross domestic product (GDP) in FY19, lower even than Kenya and Senegal, which have ratios of 3.9 per cent and 4.2 per cent, respectively (OECD Revenue Statistics).

In a recent IDFC Institute paper, we looked at the histories of countries that have managed to build strong fiscal capacity through widening their income tax base to draw out lessons for India. We studied income tax data from four countries – the UK (United Kingdom), the US (United States), France and Japan – from 1913 to 2017. Collections shot up in these countries – primarily the US and the UK – due to their governments seizing on the need to increase fiscal capacity through taxation because of the two World Wars.

In the US, the income tax-to-GDP ratio rose from 2.2 per cent in 1942 to 9.2 per cent in 1944 on the back of a drastic growth in the income tax base in roughly the same period from 11 percent of the population to 34 per cent. For the UK, the income tax-to-GDP ratio jumped from 1.93 per cent at the beginning of World War I in 1914 to 19.18 per cent by the end of World War II in 1945 – again, driven by a tax base growth from less than 10 per cent of the population prior to the wars to almost 30 per cent by their end.

Crucial to this growth was the manner in which both countries built State capacity in terms of tax administration. The US Treasury department, for instance, more than doubled its personnel from 45,000 employees in 1940 to 95,000 in 1946. There is a direct lesson here for India, where the ratio of tax administrators to population is one of the lowest in the world at one to 6,600.

Compare this to China’s ratio of 1 to 1,082. Not coincidentally, the proportion of China’s population being taxed rose from 0.1 percent in 1986 to almost 20 percent in 2008 – largely due to exemption levels staying constant and in line with growth in per capita income.

The second lesson from the US and the UK is a far trickier one. The wars gave their push to increase their tax bases’ political legitimacy and ensured citizen buy-in. India has no such shortcut to this legitimacy. It must build it the hard way – by delivering on core commitments in delivery of public goods and services and fostering public trust. Short-term measures such as raising exemption levels as a stimulus tool for the middle class are the easy way out. They do nothing to break the vicious cycle of poor fiscal capacity leading to poor delivery and thus lack of citizen buy-in and poor tax collection.

To break this cycle, the Indian State must build the capacity of its tax administration along the lines recommended by the various tax reform committee reports. The Tax Administration Reforms Commission (2014) reports stated that ramping up capacity should be a priority allowing for lateral hiring of tax specialists.

But capacity building must also focus on effective training of existing officers that is more specialised and far more rigorous. The committee recommended that all trainings have a customer focus and make it relevant to the domains the officers specialise in from the analytics department to the customer relationship and tax grievance cells. In addition, there must be budgetary provisions for deputing officers on specialised courses and seminars, and engaging with academic institutions and policy think-tanks.

Income tax is central to the modern social contract between the citizen and the State. Widening the income tax base does more than an increase in fiscal capacity. It strengthens democracy by making the government accountable to people. If citizens pay taxes, then the visible and direct outcomes matter to them. And when citizens care, the State remains accountable.

Sharmadha Srinivasan is Associate and Prakhar Misra is Senior Associate at IDFC Institute. Views are personal.

Moneycontrol Contributor
Moneycontrol Contributor
first published: Jan 30, 2020 04:23 pm