Increase the base, not the rate

Written by Nilanjan Banik | Updated: Feb 28 2013, 06:17am hrs
How does one say whether a Budget is good or bad The general reasoning for a good Budget is that it is one that contains the fiscal deficit, carries on with the necessary reforms, beefs up planned capital expenditure and curtails non-planned spending while increasing the revenue receipts. Controlling the budget deficit is an important factor from the perspective of sovereign rating, with countries with higher fiscal deficits generally losing out in terms of investor attractiveness. For the last fiscal year, Indias fiscal deficit (Centre-state combined) was around 9%, highest when compared with other BRIC economiesChinas 1%, Brazils 2.8% and Russias minus 1%. A lower foreign capital inflow on account of a higher fiscal deficit has broader implications in terms of deteriorating foreign exchange reserves, depreciating rupee, and even higher inflation, something that will make policymakers worry.

For the benefit of the reader, it may be recalled that the government Budget has two broad headings, namely, the revenue account and the capital account. The revenue account corresponds to income gained and expenditure incurred during the course of any fiscal year. Typically, in the revenue account, the expenditures are consumption-oriented, and do not have long-term asset and liability consequences. The capital account, on the other hand, consists of expenditure meant for creating long-term assets, such as building roads, ports, hospital, research and development, etc. Controlling the fiscal deficit, therefore, is to control both the revenue and capital deficits.

Although most of the discussion on the Budget is centered on controlling the fiscal deficit, it is the revenue deficit that is more important. This is because the revenue deficit arises out of the current consumption-oriented expenditure of the government (including interest payment for the earlier deficit), which does not augment the productive capacity of the country. For India, the Centre-state combined deficits have been growing rapidly during the past few years. A large part of the growth in the combined deficit can be attributed to the states fiscal deficit. The interest payment component on the earlier deficit is increasing. It also implies that cumulative government debt is increasing. Following reforms, there is now a limited scope for the monetisation of the deficit (or printing money to finance the deficit) and this has led to an increase in market borrowings by the central government. The rising proportion of internal debt has become more acute, especially with fewer disinvestment opportunities, and less recoveries of loans.

The rising proportion of internal debt in total debt is something that can be considered worrying.

Given this background, the road map to a good Budget is to control revenue expenditure. The primary components in revenue expenditure are subsidies, defence expenditure, and salaries. As the salary component cannot be reduced, in the coming Budget it is expected that the FM is going to reduce allocation to defence, subsidies, and some welfare schemes such as MGNREGA.

There is now a consensus that subsidies on non-merit goods should decline and those on merit goods should increase. This will enable the FM to set aside money for the governments pet project, the Food Security Bill.

Another idea that is floating around is that the FM may increase the direct tax rate. As a part of the reforms, the government could not raise indirect taxes to increase its revenue. Operating under the aegis of the WTO, it is difficult for a country to raise its tariff barriers. Therefore, a loss in customs revenues is more likely to happen as a result of tariff-reducing trade liberalisation. Again, given the current economic condition, especially considering the slow-moving automobile and housing sector, the FM will have less flexibility in increasing excise tax. Raising indirect tax may attract lots of attention from the industry houses.

This has made the case for raising direct tax. But will it make sense to raise direct tax If history is any indication, then the answer is no. Starting from the big bang reforms of 1991, and much through the 1990s and early 2000s, there has been a reduction in the direct tax rate. In spite of this reduction, the share of direct taxes in gross tax revenue increased sharply from 19.1% in 1990-91 to 38.8% in 2002-03. Average buoyancy, as measured by the ratio of change in tax revenue to the change in GDP at current prices, has shown substantial improvement.

There has been an increase in direct tax revenue even when tax rates were lowered. This becomes evident while looking at the period of maximum decline in marginal personal income tax rate. From 1991-92 until 1995-96, personal income tax rates came down from the maximum marginal tax rate of 56% on income above R1 lakh, to 30% of income above R1.2 lakh. However, this has not resulted in a reduction in revenue collections. The buoyancy of personal income tax revenues rose from an average of about 1.1 during 1986-87 to 1990-91 to around 1.5 during 1991-92 to 1995-96.

When the then FM P Chidambaram went for a sharp direct tax cut in 1997 (see graph), the effective tax rate declined from 22% to 16.3%. Some economists did quick calculations and came to the conclusion that revenue would be 25% lower. However, they were shortly proven wrong when, a year later, the results of the Chidambaram experiment were out. Instead of declining by 25%, tax revenues stayed constant, thanks to the large increase in compliancefrom 5.5 million taxpayers the year before to 6.8 million in 1997-98. Over the next six years, overall performance increased by 50%, from 11.9% of the tax-payer population to 18.2%.

If history is any indication, then raising the tax rate is not a good idea. It will reduce tax compliance and will lead to greater tax evasion. Instead, the FM may want to try to look at how to widen the tax base. Also, what is desired is to settle issues relating to compensation for central sales tax. This will make the implementation of GST much more viable.

The author is professor, Institute for Financial Management and Research, Chennai.