With the Union Budget due in February, the focus is on tax measures that the Finance Minister may take to address the slowdown, especially in consumption. In a discussion moderated by Suresh Seshadri , D.K. Srivastava (Chief Policy Advisor, Ernst & Young, India) and Surajit Mazumdar (Professor of Economics, Centre for Economic Studies and Planning, Jawaharlal Nehru University) look at the possibility of changes in the income tax framework in the wake of recommendations submitted in August by a committee to review the direct tax regime. Edited excerpts:
What is the likelihood of changes to the direct taxes regime, including in income tax? And what would the rationale be?
D.K. Srivastava: We have to evaluate options available to the government, in terms of the overall situation of government finances as well as in terms of the challenges to economic growth. So far, no fiscal stimulus [measures] that have been announced from time to time have delivered any result. The monetary stimulus, which has been going on since the beginning of 2019, has also not delivered any result. So, the momentum of slowdown appears to be continuing. And the impact of that is on government revenues, particularly Central government tax revenues, which will also impact the State governments.
So, in some sense, we now have a conflict. The conflict is that if we tend to reduce the income tax rates and bring them, at least the highest rate, in alignment with the lower CIT (corporate income tax) rate, then there would be a revenue loss. At the same time, there would be some additional disposable income in the hands of middle-income groups, who may increase their consumption, which would be a benefit. So, lower capacity for the government to make direct increases in expenditure, but it has an indirect capacity, which it can put in the hands of the personal income tax assessees. So, we have to now evaluate this balance.
My assessment is that the impact on government revenues, particularly the Central government’s gross tax revenues, is going to be very huge because of the under-performance of indirect taxes and because of the revenue impact of CIT. As such, the options available for the government may be very limited and in that sense, whatever income tax reforms may have to be undertaken will have to be modulated to recognise the constraints that are operating on the Indian economy.
The task force on the direct tax code is reported to have recommended an increase in the number of income tax slabs including some rationalisation in the rates and an increase in the peak rate for the highest earners. Does this move the income tax regime to a more progressive one?
Surajit Mazumdar: I think there’s always a case for changing our slab structure to make it a little bit more progressive than it actually happens to be at the moment because there’s a very large range of incomes which happen to be taxed at the same rate. However, if the idea is to reduce the revenues that the state is going to get from income taxes because of concessions, then I think that hardly solves the problem that we are facing in the economy today, for several reasons: First, if you reduce the income tax, and correspondingly cover for the revenue loss by reducing spending by the government, then it really has no effect ultimately on the total expenditure in the economy because you’re replacing one expenditure with another — a certain expenditure with a more uncertain expenditure. Second, how many people pay income tax in this country? Roughly about 6 crore people file income tax returns. Within that 6 crore almost 5 crore pay practically no tax. So it’s a very small proportion of your population which is going to be affected by any reduction in income tax. And the problem for the economy today is that its demand base is too narrow. So if you try and expand demand only in that narrow base, that’s not necessarily a resolution of the problem of the slowdown that you’re facing.
Overall personal income taxes account for less than 2.5% of the GDP. So even if you make a small reduction in that, it’s really not going to have any significant impact on the slowdown. In the longer term, however, I think we are in an economy in which we have a tax structure that is too heavily weighted in favour of indirect taxes as well as a low tax-to-GDP ratio. So, in the longer run, we should be moving towards a larger proportion of direct taxes. And, therefore, a reduction in direct taxes is not the way to go either in the short term or in the long term.
There have been attempts in the past as well to usher in reforms on the direct taxes front. Now, given the current fiscal constraints, again there is a problem. But then there would also be a school of opinion which would say: ‘The fiscal pressure can’t get worse than this. So probably bite the bullet now’.
D.K. Srivastava: A good framework would be to put in perspective what is the long-term reform that we want in the case of direct taxes. Now, as far as CIT is concerned, already the major step has been taken. And there has been a significant reduction in the CIT rates in order to attract foreign investors, foreign companies to set up their operations in India. So far, there has been a very lukewarm response. But nevertheless, I think we have to give this entire initiative some time. Now, having already considered that for CIT rates the norm is going to be 25%, with a conditionality for new manufacturing companies at 15%, we may not be able to keep, in the long run, our personal income tax rates, particularly the highest slab rate, much out of alignment with the CIT rate.
So, in some sense what the Ministry of Finance needs to do is at least indicate to us what is the desired long-term framework that the government is looking at, even if the present constraints may not allow us to go all the way towards that framework. In my view, the CIT rate predetermines, in some sense, the options that are available for the personal income tax (PIT) rates.
We should not actually increase our exemption limit because of the whole issue of how many people are our tax assessees. If we keep increasing the exemption limit, then obviously our tax base would become narrower. So while keeping the exemption limit where it is, maybe allow a small inflation adjustment. But other than that, I think the options are going to be very limited as far as PIT is concerned.
There are also suggestions that you need to try and move towards a more flat rate on income taxes.
Surajit Mazumdar: If you look at taxes as a whole, the base is a lot wider than it is for personal income tax directly. Because a substantial part of our taxes, two-thirds of our tax revenues — Central and State governments’ — come from indirect taxes, which are paid by sections of the population which may not be covered under personal income tax. So, if you have this kind of a structure where you have a flat rate of personal income tax and a substantial dependence on indirect taxes, then that is something that makes the tax structure pretty regressive. And that’s not a desirable result from an equity perspective or even from a growth perspective. If you look at the trajectory of the Indian economy, even in periods of relatively better growth, the reason you’re not able to sustain that high growth is that the kind of distribution of income resulting from that growth is too skewed in favour of a relatively small section of the population. And if that is the outcome, you have a dependence on a very narrow demand base, which is what is leading to the problem that you’re facing today. So, if you are going to address that problem, then your tax structure has to become more progressive rather than regressive. So, I would not be in favour of a flat income tax structure. I would think that there is much greater scope to improve compliance, not necessarily by a reduction in rates or having a flat rate, but by having a proper tax administration and improving the efficiency of the tax administration.
With respect to direct taxes, is the Budget going to be more one of making policy statements and less of actual measures that would make a difference to people’s pockets?
D.K. Srivastava: Yes, I think in the case of direct taxes, the Budget will only spell out incremental changes in the PIT structure; CIT there may not be much because already most of the action has taken place. And I think the constraint on stimulating demand is very, very severe. And the policy options available for the Central government are also, therefore, very limited. I see one method, which is also both short term and long term, that may deliver the Indian economy closer to its potential growth, and that is to start looking at the structure of government expenditure. Now, if you look at the entire saving-investment decline, which actually began from 2007-08, you will find that there are two major sectors where this has happened. One is the household sector and the other is the public sector or government sector proper. Overall savings rate erosion has been about six to seven percentage points. Half of that is due to the household sector fall in saving, and the other half is in the public sector, particularly government savings. And within the government, it is erosion in the Central government saving or increase in Central government dissaving.
Now, one way in which we can both increase demand and increase investment is for the government to really reduce its revenue deficit, reduce its dissaving, but spend on creating assets, particularly infrastructure assets.
In order to reinvigorate social sector spending, whether it’s in skills training, education or healthcare, what do you think can be done using the framework of taxation to move the needle?
Surajit Mazumdar: My view is rather contrary to the dominant view that governs policymaking. I think we need to move in the direction of greater government expenditure on all these sectors and therefore, greater revenue mobilisation also, which is also consistent with the objective of reducing the inequalities that exist in our society. So, to redress that inequality as well as to allow the government to spend more on sectors that need expenditures, one has to at least use fiscal policy. We are not having any radical programme of asset redistribution in the economy. At least, fiscal policy has to be used in a redistributive sense: in the sense of taxing those who are taking a large part of the cake and spending it on activities which bring benefits to others, but more importantly, create assets and circumstances in which sustainable long-term growth and development can happen.
D.K. Srivastava is chief policy advisor of EY India. He was a member of the Twelfth Finance Commission; Surajit Mazumdar is professor of Economics at the Jawaharlal Nehru University, New Delhi