Last Monday we had discussed the precipitous increase in recent years in the proportion of the combined debt liabilities of the central and state governments to gross domestic product (GDP), despite public declamations of fiscal prudence. Government indebtedness rose by 22 percentage points of GDP over the past eight years. The task of reversing this is monumental. It took six years from 1991 to 1997 to reduce it by a mere 5 percentage points. Today, we look at the tax story.
Over the past few years, many people came to the view that the root of India?s fiscal problem was in a declining tax/GDP ratio. Between the close of the 80s and the 90s, there was indeed a decline by about 1 percentage point. Voila, cried many, some with influence over policy-making, some without. This, amongst other factors, set off a treasure hunt for new things to tax, primarily services. It was also surely a great comfort to know that unproductive expenditures were not to blame for the state of affairs. Pleasant well being, not unlike that produced by consumption of prohibited substances.
The elasticity of tax revenues with respect to GDP in the accompanying table have been obtained by fitting the tax collection data series against GDP (or rather their logarithmic values). They tell us that for every 1 per cent increase in GDP, how much did tax revenues change in the respective periods. In the decade before reform (1981-91), direct tax collections did not quite keep pace with GDP. The fact that overall tax collections did was because of indirect taxes. Within indirect taxes, customs collections had an elasticity of 1.38, far in excess of the 1.01 for central excise. In other words, it was customs duties alone that enabled taxes to stay ahead of GDP growth.
How could customs duties grow so much faster than GDP? The answer is that import duties in the pre-reform period was no mere tax. The rupee was highly overvalued and there was a large premium for foreign exchange in the black market. Imports were licensed and the government effectively collected the premium on foreign exchange that it released to importers by way of the customs duty. Which is why smuggling and hawala flourished and all those Bombay movies were made.
After 1991, and especially after the unification of exchange rates in 1993, the premium on foreign exchange disappeared and rates of customs duty have declined leading to stagnation in collection. Customs duties stayed between Rs 40,000 and Rs 45,000 crore between 1997 and 2003.
After 1991 the bulk of tax growth came from direct taxes ? income tax and corporation tax. In the most recent period, the pace of direct tax growth has been surprisingly strong, offsetting the weaker growth in indirect taxes, testimony to the successes of measures to expand the income tax base, such as the 1-in-6 initiative. It is pretty obvious that the rise in government deficits and debts in the post-1998 period were in spite of good performance on the tax front, not because of it. The malaise as we shall see later lies in unreconstructed expenditures.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)