Column: Focus on GST and DTC first

Written by Amarendu Nandy | Updated: Jan 17 2013, 08:39am hrs
The chairman of the Prime Ministers Economic Advisory Council, C Rangarajan, has advocated a higher tax slab for the countrys super-rich individuals, than the current peak rate of 30%, as an additional source of augmenting government revenues. Indias tax revenue has been fallingfrom a high of 11.9% of GDP in 2007-08 to 10.1% of GDP in 2011-12. The budgeted tax-to-GDP ratio for 2012-13 is 10.6% of GDP, and indications are that the government is unlikely to meet the target.

Poor tax-to-GDP ratio has also meant a concomitant rise in the countrys fiscal deficitfrom 2.7% of GDP in 2007-08 to an estimated 5.8% of GDP in 2012-13. According to World Banks Global Development Finance 2012 report, India had the fifth-largest absolute debt stock among top 20 developing debtor countries. In the context of the precarious fiscal health of the economy, Rangarajan has suggested that revenue augmentation should be given equal emphasis as expenditure minimisation initiatives, such as reducing government expenditure on subsidies. Hence the proposal.

Indias income tax regime has remained stable in the past one and a half decade, guided by the philosophy of few rates, low rates post-1997 Dream Budget of P Chidambaram. There have been no changes in the personal income tax slabs of 10%, 20% and 30% in the past 15 years, though an education cess at 2%, and secondary and higher education cess of 1% of income tax applicable for all persons has been levied since 2004 and 2007, respectively. The yet-to-be-implemented Direct Taxes Code (DTC) has proposed hiking the income tax exemption limit, and has recommended retaining and widening the income limit in the existing slabs. The DTC has proposed a peak rate of 30% on individuals earning more than R2 million per annum. Rangarajans proposal for a higher tax-slab therefore does implicitly suggest a need to rework at the DTC provisions as well.

Interestingly, the call for a new peak rate has come at a time when the US Congress has recently decided to raise taxes for the super-rich Americans (individuals and couples earning more than $400,000 and $450,000 per annum, respectively) to tide over the fiscal cliff. In September last year, Frances President Franois Hollande announced a 75% tax for the super-rich and higher levies on business to reduce its fiscal deficit to 3% in 2013. Rangarajan has perhaps taken a cue from such policy responses and has suggested a similar path for India to partly address Indias fiscal woes.

While there is little disagreement about the need for focusing on revenue-augmenting policies, the proposal of taxing the super-rich requires the following consideration.

First, the proposal implies that we are operating at a point below the revenue-maximising point on the Laffer curve. Research by economists such as Martin Feldstein suggests that this may not be necessarily bad. As tax rate rises, the deadweight loss to the economy rises, so that as the rate gets close to the revenue-maximising point, the loss to the economy exceeds the gain in revenue. Therefore, policymakers should strive to set tax rates at the growth-maximising point rather than at a revenue-maximising point. This effectively means that tax rates should be set to generate enough revenue to finance the growth-maximising level of government. So, the Rahn curve, or the spending version of the Laffer curve, should be a better guide to inform policymaking in this regard.

Second, we need to be mindful of the adverse supply shock that a high tax rate on high earners could create. The average propensity to save is usually high for high-income individuals. So, a higher tax burden on the rich is likely to decrease the aggregate saving and investment rate in the economy, leading to a reduction in aggregate output and employment in the economy. At a time when growth in national output is falling, and business sentiments are low, implementing the above proposal in the upcoming Budget could further depress the economy.

Third, the relationship between tax rates and tax revenues might not be linear. It will be important to look at the effect of a rise in the peak tax rate on the taxable income of the economy. A higher marginal tax rate may not necessarily generate additional revenue, particularly if people respond in ways that result in less taxable income. There are several possibilities of how the rich might behave when their taxes rise. International evidence suggests that a higher peak tax rate could reduce work effort and business creation; a larger share of the earnings could be taken in forms that are taxed less; and money (and talent) may move offshore to lower tax jurisdictions. All these could lead to large negative economic effects, which may outweigh the positive arithmetic effect.

Fourth, in absence of robust compliance machinery, higher taxes on the rich are unlikely to get translated into higher revenues for the government. With the poor state of tax administration in India, and several routes of tax avoidance and evasion, introduction of a higher top tax rate could actually prove to be counterproductive. Plugging the loopholes in the tax system is a prerequisite to better tax buoyancy and tax compliance. This will, however, require strong political will to reform the domestic compliance machinery, and to rally international cooperation to eliminate tax avoidance opportunities.

The government should focus on implementing the DTC and GST in the upcoming Budget. These comprehensive direct and indirect tax reforms will bring about the required structural changes in the current revenue-generation model of the government. Ad hoc measures, such as higher taxes on the super-rich, can wait.

The author is assistant professor, Indian Institute of Management, Ranchi. Views are personal. He can be reached at