The finance minister has announced that the government is considering rationalising income-tax slabs to provide more money to households. Such rationalisation is an easy-to-implement tax reform which can benefit the economy.
The UPA government was well aware of the need for this reform when it presented the draft Direct Taxes Code for public discussion in August 2009. This Code suggested rates of 10% for incomes between the basic exemption limit of Rs 1.6 lakh and Rs 10 lakh; 20% between Rs 10 lakh and Rs 25 lakh; and 30% on incomes above R25 lakh. As against this, individuals are currently taxed at 10% on incomes between the general basic exemption limit of Rs 2 lakh and Rs 5 lakh; at 20% on incomes between Rs 5 lakh and Rs 10 lakh; and at 30% on incomes above Rs 10 lakh. A socialist bias in the UPA may have prevented the government from introducing the rates envisaged in the Code in 2009. However, there is a much greater justification for going ahead, simply because the country has experienced an inflation of about 10% between 2009 and now; as a result many taxpayers have moved into higher tax brackets, without their real incomes having been risen during this period. Even internationally we seem to be at the upper end of the ASEAN rate bands. Some of these countries have a lower maximum marginal tax rate than we do (for example, Malaysia has a maximum rate of 25%; Singapore and Cambodia only 15%). Even so, despite these comparisons, this reform in the current Indian context also justifies itself on merit—in terms of its effect both on public revenues and the economy as a whole.
Tax revenues, writes Arthur Laffer, will be zero when tax rates are 0% or 100%. In between these two two extremes, they will first rise with every increase in the marginal rate, reach an optimum, and then begin to decline with every successive increase in such a rate. Conversely, once such revenues have crossed the optimum, a reduction in rate will generate an increase in revenue. Where this optimum stands would obviously vary according the circumstances in which a country finds itself, and is always difficult to estimate.
The world’s experience with the Laffer Curve has, at best, been mixed. Reduction in taxes has not always yielded higher public revenue. India’ experience, however, has been different, whenever this reform has been implemented—Indira Gandhi, for example, decreased the maximum rate from 97.75% in 1974-75 to 77% in 1975-76 and 66% in 1977-78. As expected by the policy-makers of the time, personal income-tax revenues spurted from Rs 362 crore in 1974-75 to Rs 480 crore in 1975-76 and Rs 542 crore in 1976-77. Between 1985-86 and 1987-88, VP Singh lowered the maximum tax rate from 67.5% to 50% and brought down the number of slabs to four. Roughly corresponding to the period of this reform (between 1984-85 and 1988-89), revenues spurted from Rs 697 crore to Rs 1,492 crore. Substantially similar results followed when tax rates and slabs were similarly rationalised in the 1990s and the first decade of this century. There is every reason to expect that taxpayer behaviour will be no different this time round.
The tax paying population in this country is a paltry 30 million as against a total population of 1,260 million and a middle class of about 400 million. Considering the size of the Indian economy, such a small population of taxpayers is unacceptable. The country has to find ways of bringing more people into the tax net, and make those already in it to declare much more accurately the incomes which they actually earn.
Three reforms are needed to achieve this. One, tax administration should become less adversarial so as to promote voluntary compliance. Two, GST is needed to create an automatic audit trail of who earns how much. Three, the government has to immediately rationalise the tax rate structure and broaden bands.
What would be the effect of rationalising the rate structure on the individual taxpayer? A part of her will goad her to work harder because she would get to keep a larger amount of the additional income she earns. Opting for more leisure will be a much more expensive option for her because it will involve loss of badly needed income. Also, unlike westerners, as a nation most of us prefer higher income to greater leisure. For a country that is struggling to deliver a higher national growth rate in GDP to its people, helping people work harder and earn more income should always be an important priority for any government.
Even more importantly, in the light of the stringent measures that the government has announced to unearth black money, those taxpayers who look upon tax evasion as a game will increasingly find that the cost of compliance is much lower than the cost of evasion. They will gradually realise that it is much easier to pay the reasonable amount of tax being asked of them rather than face the prospect of making themselves liable for huge monetary penalties and prosecution involved in concealment of income. Currently, people find it worthwhile to evade tax because they find that the cost of evasion is low, and that of compliance is high, notwithstanding our internationally competitive tax rates.
That is why revenues have hardly ever declined, when rates have been lowered in our country. Laffer may have articulated this principle in the early 1970s but this has been known to smart governments for centuries. Fortunately for us, India is perhaps one of the few countries where the Laffer principle has actually proved to have worked in modern times.
When taxpayers declare higher incomes, that much more money becomes part of the “white” economy, which then comes within the control of the country’s fiscal and monetary policies. This, in itself, would be a considerable achievement. But even more than that, when taxpayers are incentivised to work harder, they will generate more income and create the much needed investible surpluses, which can then be used to finance production of more goods and services as well as create the much needed domestic demand for them. The lack of such demand is one of the reasons why industrial production is currently slow in picking up.
Many of these arguments are substantiated historically in another manner as well—as a serious problem, black money emerged only with the shortage economy brought about by the Second World War. The approach to taxation also changed about that time, when socialistic thinking within the government resulted in levy of additional taxes on the super-rich. There was no looking back on such thinking for many decades. But it is worth recalling that prior to the War, the rates of taxes were extremely reasonable; income bands were broad; and exemption limits extremely generous. It is no surprise that tax evasion hardly existed. People just did not find it worthwhile to evade tax.
Further cuts in marginal tax rates along with rationalisation of tax slabs by the government may thus provide a more powerful impetus to the economy than even the interest rate cut recently effected by RBI. Any takers?
The author is former Chief Commissioner of Income-Tax and Ombudsman to the Income-Tax Department, Mumbai