Given the concerns of ballooning budget deficits, one aspect of government expenditures not visibly commensurate with its importance is the slew of tax exemptions. This is not just a matter of a direct hit on the deficit; the broader effects on economic behaviour and investment are likely to have large multiplier effects.
The set of concessions, exemptions and incentives are known as ?tax expenditures?, a term coined by the US Treasury in the sixties. At first glance, this sounds like an oxymoron; taxes are revenues. The increasing use of this terminology, though, reflects a view that tax breaks should be viewed as a form of spending. Like direct expenditures, foregone tax revenues crowd out other spending and require higher tax rates than otherwise necessary. Done right, tax incentives can advance social objectives, both institutional and individual. Otherwise, they end up squandering resources. There is voluminous public discussion on the benefits and required rationalisation of direct expenditures, but comparatively little, at least that I have seen, of the ?tax expenditures?.
India is one of the very few emerging markets that actually provide estimates of the magnitude of tax exemptions, including a ?Statement of Revenue Foregone? in its Budget. But the extent of these revenue losses needs to be studied a bit more carefully, beyond the scope of the numbers in the statement. For one, these estimates are ?static?, that is, they assume there would be no change in economic behaviour if they were eliminated. These numbers are estimated as the revenue gained by eliminating a particular provision. This implies that ?tax expenditures? might be much larger, given the secondary and tertiary economic effects. In addition, the cost of a direct expenditure programme would probably be lower since it produces secondary income that would also be subject to tax. All of this makes a cost-benefit analysis of exemptions difficult.
The statement itself acknowledges that ?the estimates are based on short-term impact analysis? and that ?the interactive impact of tax incentives could be very different from the revenue foregone calculated?. A paper by Leonard Burman and others recently showed that in the US the interactions among tax expenditures could be quite significant. Switching between exemption schemes like TEE or EET are, under certain assumptions, economically equivalent, but the time pattern of revenue losses are very different.
After recording these concerns, some basic trends emerge from the statement. First, the ?tax expenditures? are significant. Revenues foregone in FY10 were 1.9% of GDP, almost a third of the 6.7% fiscal deficit. Without the exemptions, the fiscal deficit would have been 4.8%. At Rs 1.16 lakh crore, the revenues foregone in 2009-10 have increased 56% since 2006-07, although they have remained relatively stable in relation to the GDP. Exemptions to corporates account for over two-thirds of these tax breaks. Was it worth it?
The efficacy of exemptions for fostering certain economic objectives is not evident. At first glance, deduction of export profits of software and technology parks and export-oriented units (EOUs) seem to have yielded results. They account for 18% and 10%, respectively, of corporate revenue exemptions. Given that the share of EOUs in total exports has nearly doubled from 11% in 2005-06 to 20% in 2008-09 and the benefits of software and ITeS in fostering employment and services exports, in terms of primary impact, these might actually be defensible.
In particular, the distributional impacts of these tax expenditures need to be understood more comprehensively, building on the corpus currently available from statutory bodies like the 13th Finance Commission and think-tanks like NIPFP. Personal income tax exemptions, for instance, mostly on account of investments (Section 80C), are designed inter alia to boost retirement savings and increase insurance cover. Whether they are actually catalysing long-term savings behaviour or being treated simply as tax savings vehicles is not clear.
Amongst corporates, the distributional advantage for larger corporates is more evident. The effective tax rate (ETR) for companies with profits before tax (PBT) greater than Rs 500 crore is 22%; for those less than Rs 1 crore it is 26%. For various PBT slabs in between, the ETR falls monotonically. The ratio of taxable income to PBT, looking at another angle, for the latter companies (PBT less than Rs 1 crore) is 80%, compared to 67% for the entire sample. This indicates less deviance from PBT for smaller companies. The reason, probably, is the higher tax concessions either available or being availed of by larger companies. The ETR for public sector companies is 27%, compared with 22% for those in the private sector.
Major tax structure changes have been proposed. The GST and the direct taxes code seek to streamline many of the convoluted and labyrinthine tax measures, both in tax structures and of exemptions. An understanding of the effects of changes in the exemption structures has presumably been an important input into their design.
The author is vice-president, business and economic research, Axis Bank. These are his personal views