Column : The virtues of tax reform

Written by Nirvikar Singh | Updated: Oct 18 2012, 07:37am hrs
Last month, I introduced the idea of virtuous growth, which includes the fairness objective of inclusive growth as well as an additional goal of building positive human values. I gave the example of local government reform in India as a practical step towards virtuous growth. Giving people more responsibility over public spending at the local level has the potential to increase the quality and level of civic engagement.

The issue of local government reform in India actually requires a rethink of Indias structure of tax authorities. Currently, the system in operation gives the Centre more tax authority than the states. Local governments have very little scope for taxing their constituents. These statements need to be qualified, of course. State and local governments in India actually tax less than their power to do so. One reason for this is that there is an elaborate system of sharing central tax revenue to the states, and state tax revenue to local governments. There is some justification for collecting taxes at higher levels of governmentit can be more efficient, and less distorting of individual economic decisions. But transfers distort the revenue-raising decisions of the recipient state governments.

One way to get the efficiency advantages of higher-level government tax collection and the incentive advantages of a lower-level government tax authority is to allow piggybacking of lower-level governments on the higher-level governments taxes. This has not really been done in India. The Constitution of India assigned different tax bases to different levels of government. For example, the Centre was given the authority to tax non-agricultural income, while the states were given the authority to tax agricultural income. This was one of the worst features of Indias tax system, since the states lacked the political will or capacity to tax farmers, even rich ones, and it also provided a route for disguising non-agricultural income and evading tax on that income.

In any case, the idea of different governments taxing the same base did take hold in India, using loopholes in the constitutional language. For example, state-level sales taxes and central excise duties were imposed on the same goods. This turned out to be very inefficient, since there was no coordination or transparency, and because one governments taxes were imposed on values that included taxes by another government. The value added tax (VAT) system introduced in India a few years ago began to deal with this major inefficiency. The planned goods and services tax (GST) will extend the efficiency principles of the VAT to a broader array of commodities, and include services as well.

The details of the GST still need to be worked out and bargained over. Since it replaces existing taxes, the state governments, in particular, are worried about losing revenue as tax rates and tax shares are adjusted. The Centre needs to do more to sort out these problems and create a winning coalition for reform. One feature retained by the GST is likely to be fixed tax rates for the Central and state portions of the tax: the 13th Finance Commission follows the GST Task Force in recommending rates of 5% and 7%, respectively.

A piggybacking approach would allow states the possibility of increasing their individual rates up to some maximum level. One state might choose a rate of 8%, another of 7.5%, for its GST portion. The GST structure easily allows for this possibility. Piggybacking can go further. Urban and rural local governments could be allowed to add their own surcharges, up to some maximum. For example, one city might choose an additional 0.25%, another 0.5%. The point of these surcharges is that the lower-level government decides the rates. Surcharges can be determined by elected representatives or by referendathe key idea is that, at the margin, the residents of a jurisdiction decide to tax themselves to finance public goods within their jurisdiction.

One could potentially extend piggybacking to the personal income tax, but the GST is an easier place to start, and the occasion of introducing something new like the GST can open the door for this additional innovation. The key idea is that piggybacking allows communities to make public revenue decisions at the margin, rather than relying only on transfers from a higher level government. Civic engagement should not be just about spending, but also about financing that spending. A modern information system for administering the GST would allow local surcharges to be collected and distributed. All of this is done in the US, for example.

One of the big problems in Indias governance is that individuals do not see the connection between the taxes they pay and the services the government provides. Individuals can see this connection better if they decide on taxing themselves at the margin, in small enough constituencies so that their decisions have weight. Piggybacking on a broad tax base avoids the problem of only being able to tax small activities, and reduces the cost of administering and collecting local taxes. It may even make it easier to get a consensus agreement on the GST, giving states more flexibility as well. Freedom combined with responsibility can be a virtue.

The author is Professor of Economics, University of California, Santa Cruz