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Home » MBA Articles » MBA - Banking Articles » Indian Tax Reforms Impact of Proposed Tax Reforms on Indian Economy

Indian Tax Reforms Impact of Proposed Tax Reforms on Indian Economy

CLICK HERE : Expert Suggestions on Computer Based CAT : 2017 - 2018

Abstract

There
have been major changes in tax systems in several countries over the
last two decades for a variety of reasons. The objective of the paper is
to describe and assesses the introduction of
new forms of direct and indirect taxes, and their
revenue and the successes achieved in their implementation. The paper
concludes that after the periods of reform improving the tax system
remains a major challenge in India. The
philosophy of tax reform has undergone significant
changes over the years in keeping with the changing perception of the
role of the state. With the change in the development strategy in favour
of market determined resource
allocation, the traditional approach of raising revenues
to finance a large public sector without much regard to economic
effects has been given up. The recent approaches to reform lay emphasis
on minimizing distortions in tax
policy to keep the economy competitive. Minimizing
distortions implies reducing the marginal rates of both direct and
indirect taxes. This also calls for reducing differentiation in tax
rates to reduce unintended distortions in
relative prices. To achieve this, the approach suggests
broadening of the tax bases. Thus, over the years, emphasis has shifted
from vertical equity in which both direct and indirect taxes are subject
to high marginal rates with
minute differentiation in rates, to horizontal equity in
which, the taxes are broad-based, simple and transparent, and subject
to low and less differentiated rates. Equity in general, is taken to
mean improving the living
conditions of the poor. This has to be achieved mainly
through expenditure policy and human resource development rather than
reducing the incomes of the rich as was envisaged in the 1950s and
1960s.

Key Points:


TRC, VAT, GST, Personal Income, Horizontal equity, Direct & Indirect Taxes

Conventional wisdom on tax reforms provides us three different model of tax reform:

The Optimal Tax (OT) Model
is satisfactory in terms of its theoretical soundness,
but has been found to be impractical in its applications. Besides the
trade-off between efficiency and equity in tax policy, the information
and administrative costs of designing an optimal tax model have been
found to be prohibitive and, therefore, as a practical guide to tax
policy this has not been useful.


The Harberger Tax Model (HT)
like the OT model is well grounded in theory. It,
however, draws much more on practical experience. According to this,
while efficiency (and distribution weights) is clearly desirable in the
design of tax policy, administrative capability is equally, if not more,
important. The principal concern, according to this approach, is not to
design a system that will be optimal, but emphasize the system that
will minimize tax-induced distortions and at the same time be
administratively feasible and politically acceptable. In fact, Harberger
suggests that tax reformers should pay less attention to the economic
methodology and more to best practice experiences. The basic HT reform
package for developing countries that are price takers in the
international market consists of,
inter alia, a uniform tariff and a broad-based VAT (value-added tax).

Supply-Side Tax Model (SST) this
model emphasizes the need to reduce the role of the state. Reduction in
the volume of public expenditures
has to be achieved by cutting the tax rates,
particularly the direct tax rates to minimize disincentives on work,
saving and investment. The proponents of this model emphasize the need
to broaden the base with minimal exemptions
and preferences and to have low marginal tax rates.
Again emphasis is on minimizing distortions in relative prices and,
therefore, the approach emphasizes less rate differentiation.

The
recent reform approaches combine
elements of all three models sketched above. This
incorporates both theory and past reform experiences and takes into
account administrative, political and information constraints in
designing and implementing reforms. The thrust
of this approach is to enhance the revenue productivity
of the tax system while minimizing relative price distortions. The best
practice approach has attempted to make the tax systems comprehensive,
simple and transparent. As
mentioned earlier, the general pattern of these reforms
has been to broaden the base of taxes, reduce the tax rates and lower
the rate differentiation both in direct and indirect taxes. A broader
base requires lower rates to be
levied to generate a given amount of revenues. Lower
marginal rates not only reduce disincentives to work, save and invest,
but also help to improve tax compliance. More importantly, broadening
the tax base helps to ensure
horizontal equity, is desirable from the political
economy point of view as it reduces the influence of special interest
groups on tax policy, and reduces administrative costs.

In the
case of indirect taxation, the reform
agenda includes the levy of a broad-based VAT with
minimal exemptions and supplemented by a few luxury excises. As regards
import duties, quantitative restrictions should be replaced by tariffs,
export taxes eliminated, and
dispersion in tariffs should be minimized. Personal
income tax too is to be levied on all but a small number of persons with
income levels less than twice the per capita income of the country.
Much of the direct taxes should be
collected by withholding, but for the "hard-to-tax"
groups, presumptive taxation is to be applied. Emphasis on horizontal
equity also implies emphasis on strengthening administration and
enforcement of the tax and the development
of proper information systems and automation.

IMPACT OF TAX REFORMS SINCE 1991

Report of the Tax Reform Committee (TRC)

Tax
reform since 1991 was initiated as a part of the structural reform
process, following the economic crisis of 1991. In
keeping with the best practice approaches, the TRC adopted an approach
of combining economic principles with conventional wisdom in
recommending comprehensive tax system reforms.
There are three parts in the report. In the first
interim report, the Committee set out the guiding principles of tax
reform and applied them to important taxes namely, taxes on income and
wealth, tariffs and taxes on domestic
consumption. The first part of the final report was
concerned mainly with the much-neglected aspect of reforms in
administration and enforcement of both direct and indirect taxes. The
second part of the report dealt with
restructuring the tariff structure. In keeping with the
structural adjustment of the economy, the basic principles taken in the
recommendations were to broaden the base, lower marginal tax rates,
reduce rate differentiation, and
undertake measures to make the administration and
enforcement of the tax system more effective.

The reforms were to
be calibrated to bring about revenue neutrality in the short term and
to enhance revenue productivity of the
tax system in the medium and long term. The overall
thrust of the TRC was to:

* Decrease the share of trade taxes in total tax revenue.

* Increase the share of domestic consumption taxes by transforming the domestic excises into VAT and
* Increase the relative contribution of direct taxes.

The
important proposals put forward by the TRC included
reduction in the rates of all major taxes, viz. customs,
individual and corporate income taxes and excises to reasonable levels,
maintain progressivity but not such as to induce evasion. The TRC
recommended a number of measures to
broaden the base of all taxes by minimizing exemptions
and concessions, drastic simplification of laws and procedures, building
a proper information system and computerization of tax returns, and a
thorough revamping modernization
of the administrative and enforcement machinery. It also
recommended that the taxes on domestic production should be fully
converted into a value added tax, and this should be extended to the
wholesale level in agreement with the
states, with additional revenues beyond the
post-manufacturing stage passed on to the state governments.

In
the case of customs, the TRC recommendations were the weakest. The TRC
recommended tariff rates of 5, 10, 15, 20,
25, 30 and 50 to be achieved by1997-98. The tariff rate
was to vary directly with the stage of processing of commodities, and
among final consumer goods, with the income elasticity of demand (higher
rates on luxuries). Excessive
rate differentiation (seven rates) and according varying
degrees of protection depending on the stage of processing has been
severely criticized by Joshi and Little when they state, ".this
is a totally unprincipled
principle, for it has no foundation in economic
principles". In addition to continued complexity, the proposed tariff
structure creates very high differences in effective rates and provides a
higher degree of protection to
inessential commodities. The TRC recommendation also
falls much short of developing a coordinated domestic trade tax system
in the country. This, in a sense, is understandable, as it had no
mandate to go into the state level taxes.
However, the Committee was aware of the serious problems
of avoidance and evasion in respect of sales taxes levied by the states
predominantly at the manufacturing stage. Therefore, it did recommend
the extension of the central VAT
to the wholesale stage with the revenues from the
extended levy assigned to the states.

Revenue implications of reforms

The
economic crisis of 1991 resulted in a significant decline in revenues.
Although
the tax reforms were intended to be a revenue neutral
exercise, the natural consequence of a significant decline in tax rates
was to reduce revenues. As there was no commensurate increase in the tax
base, the revenue naturally
showed a declining trend. Thus, the tax-GDP ratio, which
was over 16 per cent in 1990-91, declined sharply to less than 14 per
cent in 1993-94. Although thereafter there has been some improvement, it
still remains less than 15 per
cent and this remains a matter for concern. Thus, the
reforms in the Indian context have in fact, caused an immediate loss of
revenues, though in the next few years, they are likely to reach
pre-reform levels.

Interestingly,
in spite of significant reductions in the rates of both
individual and corporate income taxes, the revenues have shown a
significant increase. The share of revenue from direct taxes showed a
significant increase as a proportion of
GDP as well as total tax revenue. The contribution of
revenue from direct taxes, which was less than 14 per cent in 1990-91,
increased sharply to 24 per cent in 1997-98. However, it is not clear to
what extent the increase in
revenue productivity is due to increase in public sector
wages following the implementation of pay commission recommendations,
how much of this is attributable to better compliance arising from lower
marginal tax rates and how much
due to administrative measures. There is also a
commodity tax at the local level called "octroi". This is a tax on the
entry of goods into a local area for consumption, use or sale. This tax
is levied by urban local bodies and is
levied in many states.

The decline in the tax-GDP
ratio since the reforms were initiated has to be attributed to lower
yield of indirect taxes. Naturally, some reduction in customs revenue
was only to be expected as the
prevailing tariffs were extremely high and had to be
drastically reduced. For the same reason, the reforms in excise duties
were to be calibrated to compensate revenue loss from import duties.
This, however, did not happen and in
fact, the revenue from union excise duties showed a
drastic decline. Analysis shows that the revenue from import duties as a
ratio of GDP declined by 1.3 percentage points from 3.9 per cent in
1990-91 to 2.6 per cent in 1997-98.
However, decline in the revenue from excise duties was
faster, by 1.5 percentage points from 4.6 per cent to 3.1 per cent
during the same period. Consequently, the share of excise duties in
total revenue declined by about 7
percentage points (from 28 to 21 per cent) as compared
to a 6 percentage point decline in the share of customs (from 24 to 18
per cent). Significant improvements in the tax ratio, therefore, have to
come from improvement in the
revenue productivity of domestic indirect taxes.

The
continued heavy reliance on import duties as a source of revenue rather
than as an instrument of protection is an issue that merits some
discussion. It has been pointed
out that the central government does not have the
incentive to raise revenues from the taxes that are shared with the
states.

Shortcomings & Challenges

After
eight years of tax reform, as already
mentioned, a number of disquieting features in the tax
system still remain. Improving the productivity of the tax system
continues to be a major challenge in India. The tax ratio is yet to
reach the pre-reform levels. Although the
coverage under income tax has shown significant
improvement, much remains to be done to reach the hard-to-tax groups.
The ratio of domestic trade taxes in particular has continued to decline
and this has posed a major constraint in
reducing tariffs which is necessary to achieve a
locative efficiency. Designing of tariffs itself needs to be re-examined
to ensure lower tariffs a well as a low level of dispersion to ensure
that effective rates of protection are
as intended. Reforms in excise duties have not reached
the stage of achieving a simple and transparent manufacturing stage VAT.
Much remains to be done to simplify and rationalize the state and local
consumption taxes. Concerted
efforts are necessary to create a proper management
information system and automating tax returns. Above all, tax reforms
should become systemic, a continuous process to keep the economy
competitive instead of being sporadic and
crisis-driven.

In the case of direct taxes, as
already mentioned, the revenue ratio has shown an upward trend. Marked
decline in tax rates seems to have improved tax compliance, though much
of the increase seems to have come
about due to increases in public sector wages. Yet, the
revenues realized are nowhere near the potential and much remains to be
done to improve the horizontal equity of the tax system by extending the
tax net to hard-to-tax groups.
The criteria stipulated for filing tax returns has
increased the number of tax returns from less than half a per cent of
population to more than 2 per cent. But this has not brought about a
corresponding increase in revenues.
Inability to bring in the hard-to-tax groups into the
net has continued to exert pressure to increase the standard exemption
limit deductions. There is also scope for rationalizing savings
incentives.

In the case of
corporate income taxes, too, it is necessary to broaden
the tax base by minimizing tax concessions and preferences. Rather than
minimizing them, the recent coalition governments have gone about
proliferating tax incentives to
complicate the tax system and to create a wide wedge
between the nominal and effective corporate tax rates. As the companies
started using the provisions, for revenue reasons, the government
started levying the minimum alternative
tax (MAT). Thus one imperfection was sought to be
remedied through another. This has complicated the tax system further. A
complete rethinking is necessary in designing tariffs. The TRC
recommendation of having seven tax rate
categories, the rates varying according to the stage of
production, would create large dispersal in the effective rate of
protection. Levying lower rates on necessities and higher rates on
consumer durable and luxury items of
consumption enormously increases protection to these
products.

It is essential that the highest tariff rate should be
brought down to 15-20 per cent and there should be no more than three
rate categories. Unless this is
done, it would not be possible for Indian manufacturing
to achieve international competitiveness in the medium term. The most
important challenge in restructuring the tax system in the country is to
evolve a coordinated consumption
tax system. Although tax assignment between different
levels of government follows the principle of separation, as these
separate taxes levied by the centre (excise duties), states (sales
taxes, state excise duties, taxes on motor
vehicles, goods and passengers), and local governments
(octroi) fall on the same tax base, we end up in a chaotic situation
with tax on tax and mark up on the tax. Besides cascading and relative
price distortions, this results in a
totally non-transparent tax system. Development of dual
VAT a manufacturing stage VAT by the centre and a consumption type
destination based retailed stage VAT by the states is a solution, which
needs to be progressively applied.
However, neither the centre nor the states have made
appreciable progress in this regard. To achieve this, in the case of the
centre, the excise duties should be levied entirely as ad valorem levies.
The rates should be rationalized into a maximum of two
and tax credit should be provided on a systematic basis. For this,
developing a proper information system is imperative. At the state
level, transforming the state taxes into VAT has to be calibrated even
more carefully. Rate rationalization, systematic provision of tax credit
on inputs and those paid on previous stages, removal of competing tax
incentives and concessions, zero rating the tax on inter-state sales
all these have to be done in phases.


A major difficulty in evolving a destination
based retail stage VAT at the state level arises from the fact that the
states do not have the power to levy tax on services. As mentioned
earlier, the states can levy sales
taxation of only goods. Taxation of services is not
assigned to either the centre or the state, but the former levies taxes
on selected services based on power to levy taxes on residual items.
Proper levy of goods and services tax
would, therefore, require an amendment of the
Constitution. The central government can use this as a leverage to
persuade the states to reduce and eventually eliminate the taxation on
inter-state sales so that a levy of destination
based VAT becomes a reality.

Conclusion:

VAT
was not extended to sales tax, as sales tax is under the jurisdiction
of state government. However the state government have agreed to
introduce Sales Tax VAT
& introduced from April2005. Haryana Government has
introduced Sales Tax VAT in April2004 & Reported the experience is
to be good. The Kelkar Committee in the chairmanship of Shri. Vijay
Kelkar submitted its report in
July2004 & strongly recommended Goods & Services
Tax GST.

REFERENCES

Ahmad, Ehtisham and Nicholas Stern, The Theory and Practice of Tax Reform in DevelopingCountries


Bagchi, A, "India's tax reform: a progress report", Economic and Political Weekly, vol. XXIX,

Bird, R.M., 1989. "Administrative dimension of tax reform in developing countries", in Malcolm Gillis,ed., Tax Reform in
Developing Countries

Burgess, Robin and Nicholas Stern, 1993. "Tax reform in India", London School of Economics.

Dasgupta, Arindam and Dilip Mookherjee, 1998.
Incentives and Institutional Reform in Tax Enforcement

Harberger, Arnold, 1990. "Principles of taxation applied to developing countries: what have we learned"
in Michael Boskin and Charles McLure, Jr., eds., World
Tax Reform: Case Studies of Developedand Developing Countries.

Reform of Domestic Trade Taxes in India: Issues and Options, Report of the Study Team
(Chairman: Dr Amaresh Bagchi)


Joshi, Vijay and I.M.D. Little, . India's Economic Reforms 1991-2001 (New Delhi)





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