Friday, June 13, 2014

Why India can't do away with taxes

This article was first published in on June 10, 2014

The idea of no taxes certainly brought a spark in the eyes of middle class Indians in the last couple of months as Prime Minister Narendra Modi mulled reforming the tax system by abolishing direct taxes (income, excise and sales) during his election campaign. The very prospect of spending the spring doing better things than worrying about the optimal amount of savings to save income tax is thrilling. Particularly, after a year of high inflation that put many holes in the pocket of middle class, the idea of doing away with taxes seems to be a magnificent idea.

The Bhartiya Janta Party (BJP) later clarified that they did not mean abolition of direct taxes. They are really pitching for major reforms in the ‘taxation regime’ in its current form in India. The statements however have opened up a Pandora’s Box over the merits and demerits of a no-direct taxes regime for India.

Half of the Indian government revenues in a year come by way of tax collection. Of this half, one third comes as corporate taxes and remaining two third by way of indirect taxes and taxes on personal incomes (Figure 1).

Figure 1: Break up of Tax Revenue to Government of India (Assessment Year 2013-14)
Source: Income Tax Department, Government of India

This is a huge chunk of government revenue. So there has to be a recovery plan for this forgone revenue. As an alternate to the present taxation system, ‘Banking Transaction Tax’ (BTT) is being proposed under which a flat percent will be charged whenever an amount is credited to a bank account. Under this system, it is argued, the government will generate more revenue than the present taxation system, the problem of tax evasion and black money will be solved, and an easier way to collect taxes will be devised.

This already attracted opposition from within for BJP earlier. Senior party leaders like Arun Jaitley and Yashwant Sinha had opposed the proposal as it shifts the tax base to the entire population which has a Bank account. In addition to middle and high income class, low income class would also be subject to BTT. Also, the implementation of BTT would essentially mean that all transactions be done electronically. Let us not forget the level of financial inclusion in India. India has 10 commercial bank branches per 100,000 adults and 7.29 ATMs per 100,000 adults. Less than 60% of total households in India have access to banking services. Implementing BTT would mean leaving out the balance 40% of the households which need not necessarily comprise of poor people.

Even if we take the case of only personal income tax being abolished, it will lead to giving up 10% of the total government revenue. If no income tax were collected in the current fiscal year 2013-14, the fiscal deficit will widen from an estimated figure of 4.8% to 6.9%. This will have to be sourced from somewhere else, mainly by increasing indirect taxes and excise duty of some goods. Therefore, the common man is going to pay taxes on way or the other.

Now, let us also take a look at the countries which do not have taxes. According to a survey of 114 countries by KPMG in 2012, ten countries didn’t charge any income tax (does not include corporate income) and indirect tax (Table 1).

Table 1: Countries with no tax on personal income and indirect taxes
Source: CIA World Factbook, Various articles

Most of these countries belong to the Middle East and are rich in oil and gas resources, while remaining depend on tourism and international business. Another common feature of these countries is that most of them have monarchy as a system of governance. As regard taxes, Bahamas, Bahrain, Bermuda, and Cayman Islands do not even have taxes for corporate income. While these countries do not charge tax on personal income of individuals, all of them mandate a social security tax ranging between 4-9%. Employers are also made to contribute in certain proportion towards a pension scheme for the employees.

However, none of these countries is comparable to India. Nine out of these ten countries have population less than 1% of that of India (Saudi Arabia excluded). Seven of these countries have land area less than 1% of that of India (Saudi Arabia, Oman and UAE excluded).

Not only demographics, but India differs from these countries on major economic indicators (Figure 2).Due to their smaller population base and rich natural resources, these countries have per capita GDP which is manifold of that of India. On the other hand, India, being the fourth largest economy in the world in terms of GDP and second largest in term of population, has to deal with high inflation and budget deficit which are at convenient levels in most of these countries.

Figure 2: Economic Indicators of Zero Tax countries and India (2012)
Source: CIA World Factbook

With a large economy, very low per capita income, high inflation and budget deficit, India can’t possibly copy the taxation system of these small countries that rely on natural resources for government revenue and are among richest countries in the world.

Among these countries, many are facing problem of sourcing funds already. Qatar was considering introducing a Value Added Tax system to increase the government earnings. Kuwait was warned by International Monetary Fund in 2012 for possible shortage of public finances and had suggested introduction of direct and indirect taxation system. Bahrain was also facing problems with public finances in 2012 as increase in wages and public spending during the year had led to shortage in available funds.

It seems that the spark in the eyes of common man has to fade as of now for abolition of taxes in India will need a lot more thinking before it can be sustainably implemented. Till then, all eyes are on Mr. Arun Jaitley!