Saturday, 27 February 2016

Extract from Indian Economic Survey 2016: Fiscal Capacity

Fiscal capacity—spending and especially taxation—is key to long run economic development. Taxation is not just about financing spending, it is the economic glue that binds citizens to the state in a two-way accountability relationship.
Against this background, we assess India’s fiscal capacity. Simple tax-GDP and spending-GDP ratios suggest that India under-taxes and under-spends relative to comparable countries. But, controlling for the level of economic development, India neither under-taxes nor under-spends. India does tax and spend less than other politically developed nations, but given that most other democracies took time to strengthen tax capacity, perhaps India is not an outlier on this dimension, either. India does stand out in the number of individual income taxpayers, currently about 4 percent, far from our desirable estimate of about 23 percent.
Building long-run fiscal capacity is vital. One low hanging fruit would be to refrain from raising exemption thresholds for the personal income tax, allowing natural growth in income to increase the number of taxpayers. Beyond that, building fiscal capacity is also about creating legitimacy in the state. This can be acquired by pri

oritizing improved delivery of essential services that all citizens consume.
7.1 The Indian tax system is about to witness dramatic changes. Consider first the GST. Implementing a new tax, encompassing both goods and services, to be implemented by the Centre, 28 States and 7 Union Territories, in a large federal system, via a constitutional amendment requiring broad political consensus, affecting potentially 2-2.5 million excise and service taxpayers, and marshalling the latest technology to radically improve collection efficiency, is a reform perhaps
unprecedented in modern global tax history.
7.2 Take next corporate taxes. The rate is scheduled to come down from 30 percent to 25 percent and a wide range of exemptions will be phased out in an orderly manner. In addition, the legacy of contentious, adversarial tax issues from the past is being cleaned up.
Tax administration is being improved: now around 95 per cent of filings are electronic, tax refunds are now being issued in a record 7-8 days, and a new Tax Policy Council and Tax Research Unit are being created.
7.3 To be sure, a number of important issues in tax policy as well as in tax administration (as detailed for example, in the report of the Tax Administration Reforms Commission) need to be addressed. But ongoing developments warrant taking stock of a simple but fundamental question: Given that state capacity and taxation are crucial determinants of long run development, how can India move from its current situation to one of increasing taxes and government spending as part of the process of building state capacity ?1
7.4 The findings are nuanced but striking. 

i. A simple comparison of aggregates with other countries indicates that India undertaxes and under-spends.
ii. Controlling for the level of economic development, India neither under-taxes nor under-spends.
iii. India does tax and spend less than other politically developed nations, but given that most other democracies took a long time to strengthen tax capacity, perhaps it is not an outlier on this dimension, either.
iv. Where India does stand out is in the number of individual income taxpayers. The ratio of taxpayers to voters is only about 4 percent, whereas it should be closer to 23 percent.
7.5 We explore the policy implications of these findings in the concluding section. 

7.6 Consider first, why taxation is key to long run political and economic development. If spending is about the entitlements of citizenship in a democracy, taxation is about the obligations of citizenship. Taxation and military service (or some other form of compulsory national service) are two core
elements of modern citizenship. India has chosen taxation as the key obligation that it can demand of its citizens. The obligations of citizenship are the foundations of nation building and democracy. Bringing more and more people into the tax net via some form of direct taxation, will help in realizing the promise of Indian democracy.
7.7 Democracy is a contract between the state and its citizens. This contract has a vital economic dimension: the state's role is to create the conditions for prosperity for all by providing essential services and protecting the less well-off via redistribution. The citizen's part of the contract is to hold the state accountable when it fails to honour the contract (Besley and Persson [2013]2). But
a citizen's stake in exercising accountability diminishes if he does not pay in a visible and direct way for the services the state commits to providing. If a citizen does not pay - through taxes or user fees - he either becomes a free rider (using the service without paying) or exits (not using the service at all). Both reduce the accountability of the state. Hence the expression: no representation without
taxation. Taxation is not just about financing public spending, it is the economic glue that binds citizens to the state in a necessary two way relationship.
7.8 One can think of tax paying and political participation as two important accountability
mechanisms wielded by citizens. The precocious India phenomenon is that economic development lags political development.
One can hypothesize that this difference in taxpaying and voting might explain the phenomenon in India of there being reasonably effective episodic accountability as opposed to ongoing accountability. Independent India has averted famines but chronic malnutrition is still a challenge. The Indian state can organize mega-events but routine safety for women has turned out to be more difficult to achieve. The Indian state responds effectively to floods and tsunamis but finds water and power metering more challenging.
7.9 Consider next the challenge of moving to a better equilibrium. There are no real low hanging fruit here because of two reasons: first, India is not really an outlier, contrary to much popular perception, in terms of its overall level of taxation and spending—facts that we establish unambiguously. It is easy to exhort the government to, say, increase spending on health and education or remove
exemptions on the tax side. But it must be remembered that the ability to spend and tax is
in part endogenous to the perceived legitimacy of the state. Citizens will be willing to pay their dues as taxes only if they feel that the state is adhering to its side of the contract by delivering essential services. In other words, tax and spending policy are related to actions by the state to increase its legitimacy. State and tax capacity are as much about state legitimacy as they are about technical details relating the design of policy and its implementation.

Cross-Country Taxation and Expenditure Patterns
7.10 In this chapter we assess, in a simple cross-country framework, whether India taxes and spends enough. How does India, a democracy with (PPP adjusted) per-capita GDP at about one-seventh of the OECD average compare internationally on spending and taxation patterns? A caveat: we do not
consider property taxation not because it is unimportant. Rather, the omission owes to data challenges, stemming in part from the fact that property is taxed, albeit differently, at all three levels of government in India. This also means that the Centre has fewer policy levers at its disposal so that improving property taxation will require greater cooperation between all three levels of government. But given the extent to which property is a critical constituent of wealth and a potential source of
local government revenues, property taxation reforms should be an important part of the country’s tax reform agenda.
7.11 In the simple cross-section, India appears to be an outlier: it taxes and spends
less than OECD countries and less than its emerging market peers (Table 1). India’s
spending to GDP ratio (as well as spending in human capital i.e. health and education)
is lowest among BRICS and lower than both the OECD and EME averages. India’s tax to
GDP ratio at 16.6 per cent also is well below the EME and OECD averages of about 21 per
cent and 34 per cent, respectively.
7.12 India’s spending and tax ratios are the lowest even among economies with comparable (PPP adjusted) per-capita GDP e.g. Vietnam, Bolivia and Uzbekistan. The two ratios stand at 28 per cent and 22.2 per cent, 43.3 per cent and 25.5 per cent, 33.4 per cent and 25.6 per cent for Vietnam, Bolivia and Uzbekistan respectively for the latest year available. Table 1 also shows that India’s share of income and property tax in GDP are also comparatively low (with the exception of China in case of direct taxation).
7.13 Over time too, it seems, India has made limited progress in increasing its tax and
spending capacity. Besley and Persson (2013) document that rich countries have consistently invested in tax collection capacity and collect a larger share of income in taxes vis-à-vis poor nations (and much higher revenues visà- vis poor countries despite comparable tax rates).In comparison to the United States (which introduced income taxes over the first half of the 20th century) India’s tax to GDP ratio has increased at a much slower pace over the comparable time period following the introduction of income taxation. India’s tax to GDP ratio has increased by about 10 percentage points over the past six decades from about 6 per cent in 1950-51 to 16.6 per cent in 2013-14. Figure 1 shows ten-year snapshots of the trends in aggregate spending as well as the indirect and direct tax to GDP ratios for India starting 1960-61.
7.14 However, it may not be appropriate to make such simple cross-country comparisons
since there is a strong relationship between a country’s fiscal capacity and the level of
economic development. The correct question to ask therefore is: whether India’s fiscal
capacity is low given its level of economic development (proxied by its PPP adjusted per
capita GDP).

Number of Taxpayers: Is India an outlier?
7.28 Taxes and expenditures should be viewed not just from a fiscal but also an
institutional perspective. It is well-known that citizenship and building the economic
connection between citizens and the state happens more via direct rather than indirect
taxes which do not affect taxpayers as immediately and saliently as direct taxes.8
It appears that citizens feel the pinch of taxation most when their incomes or assets
are taxed. Especially in a country like India, indirect taxes are not immediate or direct
enough to be perceived by citizens as their contributions to the state. For that reason,
the implementation of the GST - while highly desirable and necessary - will have a limited
impact in furthering the broader objective of citizen participation, state building, and
democratic accountability. As Besley and Persson (2013) show, countries with a higher
share of income taxes in total tax collections tend to have more accountable governments.
7.29 This directly relates to the point noted earlier, that accountability of citizens weaken
if they do not pay directly for the services the state provides. This is likely to render citizens as free riders or compel them to exit thereby diluting the accountability of the state itself.
Hence the number of taxpayers is a key indicator of fiscal capacity. Does India have
too few or approximately the right number of citizens paying taxes given its level of economic and political development?
7.30 In India today, roughly 5.5 percent of earning individuals are in the tax net. This statistic gives an idea of the gap that India needs to cover to become a full tax-paying
democracy. Based on recent tax data, and using the methodology in Banerjee and
Piketty (2005), we estimate that about 15.5 percent of net national income excluding
taxes (which is the national income accounts counterpart of the personal income accruing
to households) was reported to the tax authorities as gross taxable income. In the late
1990s, this number was 8.3 percent. In other words, nearly 85 percent of the economy is
outside the tax net.

7.31 Turn next to the cross-country comparisons. Here too at first blush India seems an outlier. As figures 5a and 5b show, despite the number of tax returns filed picking
up from mid-1980 onwards, India currently has amongst the lowest number of taxpayers
(as a ratio of voting age population).

7.32 However, a more rigorous cross-country analysis leads to interesting results. When we
examine the number of taxpayers (as a ratio of voting age population) controlling for
the level of economic development, India is not an outlier. It is only when we control for
the level of political development (using the democracy index) does India turn out to be
an outlier (Figures 6a and 6b). Controlling for the level of democracy, India’s ratio of taxpayers to voting age population is significantly less than that of comparable countries. This implies that while at present about 4 per cent of citizens who vote pay taxes, the percentage should be about 23.
7.33 Piketty and Qian (2009)9 compare China and India to argue that Chinese success in bringing more citizens into the individual income tax net owes to setting a reasonable threshold for paying taxes and not changing it unduly. In contrast, in India, exemption thresholds for income taxes have been consistently raised. In fact, as Figure 7 shows, thresholds have been raised much more rapidly than underlying income growth so that today, the wedge between average income and the threshold has widened.
7.34 We can calculate in some sense the “missing taxpayers” in India—not those who are evading taxes altogether or under-reporting taxes but those who have legitimately gone under the tax radar due to “generous” government policy. We ask how many taxpayers there would have been in 2012-13 if the threshold had been maintained at Rs. 1,50,000 (the threshold limit in 2008- 09). We find that there would have been an additional 1.65 crore units incorporated within the taxation system (an addition of about 39.5 percent) and tax revenues would have been about R31,500 crores greater. India’s tax-GDP would have increased by 0.32 per cent just by not having raised the threshold so generously.

Indian Top Personal Income Distribution 
Recent work by Piketty10 (2014) and his co-authors has raised a number of questions related to personal income distribution at the very top of the income spectrum. We are now able to provide some tentative estimates based on detailed tax data for the years 2012-13 and 2013-14 and compare them with the estimates produced by Piketty
and Banerjee (2005)11. The methodology for computing these estimates is far from watertight and should hence be viewed with some circumspection.
We reproduce the methodology in Piketty and Banerjee (2005) and compare our estimates with theirs. The results are shown in Figure-2 for the share of the top 1 percent, top 0.5 percent and the top 0.1 per cent of the people in the overall income distribution. We do not have data for the intervening years (between 1999-2000 and 2011-12)
and hence the blank spaces in the figure below.

As in many countries, there has been a growing concentration of income at the top: in 2013-14, these three groups accounted for 12.4 per cent, 9.4 per cent and 5.0 per cent1 of the income of the entire Indian economy respectively. These numbers are close to comparable shares in the United Kingdom and a below those in the United States. But the change between the late 1990s and today in income shares is greater than the change in the UK and similar to that in the US (Piketty [2014]).

Conclusion: Moving To A Better Equilibrium On Taxation And Spending

7.35 All that said, the foregoing analysis merely assessed the adequacy of India’s tax
base at a point in time, the present. Even today, it is evident from the analysis in this
chapter that India has not fully translated its democratic vigour into commensurately
strong fiscal capacity. In the long run, if India is to stay “on the line” as its per capita income grows, it will need to build fiscal capacity.
One low hanging fruit that we suggested was to refrain from raising exemption thresholds
and allowing natural growth in income to increase the number of taxpayers. In some ways, this would be reform through inaction.

7.36 Beyond that, what might be done, given that building fiscal capacity is essentially about creating legitimacy in the state? Four points seem relevant here. 
7.37 First, the government’s spending priorities must include essential services that all citizens consume: public infrastructure, law and order, less pollution and congestion, etc.
7.38 Second, reducing corruption— fiendishly difficult as it is—must be a high priority not just because of its economic costs but also because it undermines legitimacy. The more citizens believe that public resources are not wasted, the greater their willingness to pay taxes. In that sense, the government’s efforts to improve transparency through transparent and efficient auctioning of public assets will help create legitimacy, and over time strengthen fiscal capacity.
7.39 Third, subsidies to the well-off (amounting to about R1 lakh crore as documented in Chapter 6) need to be scaled back. Regaining legitimacy must be as much about phasing down these bounties as it is about better targeting of subsidies for the poor. Similarly, the tax exemptions Raj which often amount to redistribution towards the richer private sector will also need to be reviewed and phased out. And, reasonable taxation of the better-off, regardless of where they get their income from—industry, services, real estate, or agriculture--will also help build legitimacy.
7.40 Fourth, property taxation needs to be developed. The very fact that systematic data on property taxation across the country is so sparse is a measure of just how little attention has been given to this tax. Property taxes are especially desirable because they are progressive, buoyant (at least in the Indian context), and difficult to evade, since they are imposed on a non-mobile good, which can with today's technologies, be relatively easily identified. Higher rates (with values updated periodically) can be the foundation of local government’s finances, which can thereby provide local public goods and strengthen democratic accountability and more effective decentralisation. Higher property tax rates would also put sand in the wheels of property speculation. Smart cities require smart public finance and a sound property taxation regime is vital to India's urban future.

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