Sure, subsidies mess with government finances, but so do the plethora of tax exemptions and concessions that India offers. Could it be that the brouhaha over subsidy reduction is giving cover to a more hideous villain?
To wit: India spends a whopping Rs 2.4 trillion (as per BE FY16) directly on subsidies every year. But more than double that (Rs 5.9 trillion, as per RE FY15) goes into tax expenditures, measured as revenue foregone, which amounts to 4.7% of the gross domestic product (GDP)—more than the central government’s fiscal deficit!
A fall in subsidy burden due to a sharp drop in global crude prices propped up government finances last fiscal and continues to help. Subsidy burden for FY16 (estimated) dropped to 1.7% of GDP from 2.1% in the previous fiscal.
This was sheer luck, but it did provide an opportunity to reform the petroleum subsidy regime. And the government did make use of this opportunity by making diesel prices more market-determined—so, the subsidy burden of some of the fuel items does not move up whenever global prices go up.
Still, the overall subsidy burden remains high and there is scope for further reduction, particularly, in the case of other petroleum-related subsidies (such as kerosene), food and fertiliser.
But these estimates of subsidy burden are incomplete as they do not include the “tax expenditure” incurred due to various stakeholders—also a form of subsidy. Direct spending on subsidies—petroleum, food, fertilisers and interest costs—helps reduce individuals’ cost of consumption. Tax expenditure, in contrast, is in the nature of tax exemption, deduction, credits, or concession on tax rates or timing such as accelerated depreciation of capital assets, which may help lower or defer the tax liability of corporates and individuals.
Like direct subsidy spending, tax expenditures have declined over the years—from a peak of 8.1% of GDP in FY09—but still measure up to half of gross tax collections. Together, subsidy spending and tax expenditures (or revenue foregone due to tax concessions) add up to R8-9 trillion, or 6-7% of the GDP per year. This is huge for a country where the government spends only around 3.5% on education and just over 1% on medical and public health, water supply and sanitation.
Also, the presence of a large number of exemptions erodes the tax base and impedes a reduction in tax rate. The government intends to lower the corporate tax rate to 25% by FY20 from 30% today, while gradually withdrawing corporate tax exemptions, which are available under around 32 heads. Speaking at the University of Columbia, finance minister Arun Jaitley reiterated the NDA government’s resolve to bring the corporate tax rate down to 25% over the next four years. Even today, the effective corporate tax rate, after factoring in the benefit from exemptions, is 23.22%. The government’s intent, therefore, is right. But it takes care of only corporate tax, which is 61% of the total revenue foregone on direct taxes but a mere 11% of total revenue foregone (direct plus indirect taxes).
A larger share of total revenue foregone goes to customs duty—at 51%—followed by union excise duty exemptions at 31% . Most of these are backward or hilly area-based excise duty exemptions, which may get subsumed under GST and might receive tax credits. But exemptions in the case of customs duty are high, mainly related to imports of crude oil and minerals, diamond and gold, edible oil, fruits and cereals, and machinery. The government will need to reassess the costs and benefits on these exemptions because revenue foregone on indirect taxes is as high as 83% of the total revenue foregone and 89% of the indirect tax collections. That is not sustainable.
Today, multiple layers of taxes and the resultant inconvenience to businesses are hurting India’s competitiveness.
The country is ranked 142nd for ‘Ease of Doing Business’ (156th for the ‘Paying Taxes’ head of the rankings). As per the Doing Business 2015 report, businesses are required to make an average 33 tax payments, which take up 243 hours per year. Then, there are huge amounts stuck in tax litigation—as much as R5 trillion. A simpler tax system, with fewer exemptions, will reduce administration costs, strengthen compliance and help improve the rankings.
In case of direct subsidy spending, the government’s push towards direct benefit transfer of subsidies is a welcome step. In case of tax expenditure, too, the government should focus on better targeting. A few—but minimal—exemptions with targeted goals can stay, such as concessions for engaging in economic activity in the hilly and backward areas, tax-breaks on household savings, research & development activities and few exemptions to the exports sector.
Withdrawing tax exemptions will be no mean feat for the government. But there is larger good to be had in the form of efficiency gains—from lesser taxes paid by producers to savings on tax administration as the cost of enforcement comes down. And this does not require approval of both Houses of Parliament!
Joshi is chief economist and Deshpande is senior economist, CRISIL