Fiscal architecture for a US$5 trillion economy

The evolution of India’s tax-to-GDP ratio will require significant political and social consensus—a strategic modelling and planning of tax POLICIES is required

Financial Express

India’s tax-to-GDP ratio at the government level has hovered around 18-19% of GDP over the last few years (between FY17 and FY20E). Coupled with disinvestments, dividends, and other receipts, the central government mops up another 5-6% of GDP, taking the total revenues of the government to about a quarter of GDP. The government is committed to spend, on account of both revenue and capital expenditure, 29-30% of the country’s GDP, leaving it with a fiscal deficit in the 4-6% range. The revenue percentages for the government have remained reasonably sticky, and the expenditure items are also committed.

As India works its way towards a $5 trillion economy, or double its current size, in the next few years, it is worth considering what the fiscal landscape could look like. As Esteban Ortiz-Ospina and Max Roser note in ‘Our World in Data’, “total tax revenues account for more than 80% of total government revenue in about half of the countries in the world”. Also, “developed countries collect a much larger share of their national output in taxes than do developing countries; and they tend to rely more on income taxation to do so. Developing countries, in contrast, rely more heavily on trade taxes, as well as taxes on consumption.”

As India’s economy doubles in size and tax-to-GDP ratio rises, government tax revenues could more than double. India has various forums to opine and act on fiscal policy. India has made—and kept—some long-term promises on reducing the rate of taxation on corporate income. The Direct Tax Code report has proposed some changes in the tax structure. The Finance Commission, when it submits its report, will forecast its expectation of the taxes collected by the governments at various levels over the next five years. A model describing how India’s tax-to-GDP ratio can evolve will offer pointers on what social and political aspects need to be focussed upon to build a fiscal consensus.

Deep-diving into the drivers of tax revenue

The composition of taxes for the central government largely rests on direct and indirect taxes—and so, we will focus our attention on those line items. We note that with the rolling out of GST, the casting vote on deciding on tax rates now is with the Centre. A progressive taxation structure requires that the ratio of direct taxation in total tax collection is more than half.

Direct taxes: According to the information released by the income tax department, Rs 51 lakh crore of income was offered for taxation in AY19. The GDP in FY18 was Rs 170 lakh crore. The income from salaries offered to tax amount to rS 20 lakh crore, business income Rs 24 lakh crore, other sources Rs 6 lakh crore, and house property and capital gains make up the rest. This implies that only 30% of GDP (income) was offered to tax. The total direct taxes collected amounted to Rs 11 lakh crore, implying an average tax-incidence of 22% on the incomes offered to tax.

We know that only around 5% of citizens are registered to pay tax. From the above, we observe that less than a third of the GDP is offered for direct taxation, and where so offered, the average rate of taxation is significantly lower than the marginal rate.

Factors which could impact direct taxes as a percentage of GDP are: (a) proportions of taxpayers-to-citizens rising significantly beyond 5% as the average incomes in India increase, (b) the incomes offered to tax rising beyond 30% of GDP as the rising middle-class citizens breach threshold incomes, and consequently (c) governments being in a position to alter the marginal and average rates of taxation.

Indirect taxes: GST now forms the largest component of indirect taxes, even as customs and excise continue to remain important in international trade and for states, respectively. The total GST collection was Rs 13 lakh crore in FY19. Consumption, at 58% of GDP, amounted to Rs 100 lakh crore—this implies that the average rate of GST on overall consumption is ~13%.

Various factors that could impact indirect taxes as a percentage of GDP are: (a) consumption as a percentage of GDP could rise back to the 60%+ levels, (b) more goods and services could be offered to taxation under GST and/or (c) the rates of taxation could materially change.

Expenditure: The committed revenue expenditure of the central government is Rs 18 lakh crore in FY20. To make it easy to understand and remember, just think of this as 3-4-5-6. The central government is committed to spending Rs 3 lakh crore on subsidies (food subsidy being the largest, followed by fertiliser), Rs 4 lakh crore is spent on social development (agriculture, rural development, health and education), Rs 5 lakh crore goes in pay and pensions (and the latter is increasingly a larger share of the total pie), and Rs 6 lakh crore is the interest paid on the loans outstanding against the government.

How each of these items evolve over time, and what levers the government has on controlling or directing them will determine what is available for capital investment and defence. A concerted overhaul of the composition of expenditure is possible, especially as tax revenues more than double as the economy grows.

In a recent article, Dr Arvind Subramaniam pointed out that “macroeconomic pathologies arise from conflicts over how to divide the economic pie”. While changes to tax architecture, administration, laws, and processes are important, it is critical that underlying factors that drive tax revenues and expenditure for the government are understood, highlighted, detailed, and debated in the wider society. Building a social and political consensus on the tax architecture will help develop effective mechanisms for burden-sharing in our society.

The writer is author of The Making of India. Views are personal

The first paragraph has been updated - Nov 30, 2019.