On the eve of 25th anniversary of reforms, much has been spoken and written about reforms in India. The flood of articles in the past one week, has reminded us the genesis, the seriousness of the external payments crisis and the measures taken to tide them over and undertake structural reforms to steer the economy from a predominantly state controlled into market oriented one. We have been reminded of the precarious situation the country was in and how the political leadership and bureaucracy had to move in swiftly to change the course of India’s development strategy. It is interesting to read self-congratulatory accounts of how the balance of payments crisis was converted into an opportunity to undertake comprehensive structural reforms.
In this entire narration of historical accounts, there was virtually no discussion on the tax reform initiated as a part of the structural reform. This is perhaps due to the fact that the reforms were not immediate—they were phased in subsequent years and partly because, the major architect of reforms, Raja Chelliah is no longer there to narrate the story. To be sure, the two commissions appointed in the maiden budget of Manmohan Singh in 1991 were, one on tax reforms chaired by Raja Chelliah and another on the financial sector reform chaired by M Narasimham.
Tax policy, until then, was designed to meet the requirements of planned development strategy and as an instrument to reduce inequality in incomes and wealth. Although it had failed on both counts, the extortionary structure of income tax was a symbol to achieve the socialistic pattern of society. However, expansionary fiscal policy in the latter half of the 1980s and persisting chronic fiscal deficits required reform of the tax system. The move towards market-led development required reorientation and modernisation of the tax policy. This required changing the tax system taking into account the developments in the theory of tax reform and the best practice approaches followed internationally. Thus, the Commission had a clear mandate to recommend reforms in the tax system which will enhance revenue productivity and simplify and rationalise the tax structure and administration to meet the needs of the market economy.
The Commission set about its task systematically. Before the second budget, the Commission had given the first report to the finance minister to initiate reforms. It produced two more volumes of the report dealing with the structure and operational aspects of both Union and State taxes. The three volume report of the Tax Reform Commission provided the basis of reforms in the tax system. Interestingly, although the reforms were recommended and later carried out without any international pressure, they were broadly in conformity with the international trends and best practices. Reviewing the report of the tax reforms commission in Economic and Political Weekly, Richard Bird, one of the foremost experts on taxation wrote, “The three volume report on tax reform in India … generally offer clear and sound guidance as to what can and should be done”.
The broad thrust of reforms was to move away from the levy of extortionary rates. The attempt was to evolve a tax system broadening the base and levying lower and less differentiated rates to evolve a simpler system. Broadening the base entailed having a relook at the tax preferences. Chelliah had a competent team of scholars led by Arindam Das-Gupta to assist him. They did pioneering work on various aspects of tax policy and administration. After the exciting, which in many ways was also exhilarating, work, Arindam Das-Gupta along with Dilip Mookherjee, came out with a pioneering book, “Incentives and Institutional Reform in Tax Enforcement”. It was not easy for Raja to move away from the orthodoxy as even within the Commission there were people who believed that reduction in the rate would not lead to better compliance. Indeed, Manmohan Singh had a strategy; after the submission of the report, he appointed Raja Chelliah as the Adviser to the finance minister with the principal mandate to implement the reforms he had recommended. Thus the tax brackets in personal income tax were reduced to three at 20, 30 and 40%. The corporation tax rate too was reduced to 40% in 1993-94 budget and the distinction between closely held and widely held companies was done away with. The wealth tax on financial assets was abolished and the maximum marginal rate of wealth tax was reduced to 1%. Indeed, the reform was taken further in P Chidambaram’s dream budget; whereas NK Singh in a recent column in The Hindu noted, as the then revenue secretary, he succeeded in persuading the finance minister and the prime minister to reduce the maximum marginal tax rate to 30% and the corporation tax to 35% in the 1997-98 budget.
Raja Chelliah, as the adviser to the finance minister was always looking for opportunities to expand the base to raise revenue. In late 1992, I had written an article for a conference organised by the Asian Development Bank on, “Taxation of Services in the Asia- Pacific Region” and given my proximity, persuaded Raja Chelliah to read it before sending it to the conference. The reaction was simple. He wanted me to write on a note exploring the possibility of taxing services in India. The result was the introduction of service tax on three services in the budget of 1993 (telephones, non-life insurance and stock brokerage) and in subsequent years the coverage of the tax base was expanded steadily to make it one of the most productive taxes in terms of revenue. The report of the TRC was also the forerunner to the introduction of VAT at the state level though it fell short of recommending GST because Raja Chelliah thought that division of revenue from taxes on inter-state services will be difficult to manage. Of course, concrete proposals to move towards VAT at the state level was put forward in the report of the study team on “Reform of Domestic Trade Taxes in India” led by Amaresh Bagchi in 1995. In fact, the recommendation to evolve a goods and services tax—at the manufacturing level by the centre and retail level by the states was first recommended by the Expert Group on Taxation of Services chaired by me in 2001.
Perhaps the most difficult part of TRC work related to rationalising customs duties. The recommendation was to reduce the peak rate to 50% for all non-agricultural goods and number of rates was to be brought down. It was indeed implemented and the number of rates was brought down from 22 in 1990-91 to seven by 1997-98. While this is a considerable simplification from the structure that prevailed, it still had too many rates and the rates varied with the stage of manufactured products, with finished products attracting higher rates than inputs and this was rightly criticised by Joshi and Little as “unprincipled principle”.
Raja Chelliah virtually made the entire NIPFP reform-oriented. There were papers written on expenditure reform and those highlighting the proliferation of subsidies. Papers were also written to identify the maladies affecting state finances and addressing reforms in that area. Indeed, those were exciting times for the younger generation of scholars at NIPFP.
The author is emeritus professor, NIPFP and chief economic adviser, Brickwork Ratings Views are personal