Over the past 15 years, India has substantially revamped its tax structure. The central government has cut customs and excise duties, lowered income tax rates, extended a form of value-added tax (VAT) to some industries, and broadened the tax base to include some services. After a 10-year delay, all but two state governments have recently introduced a VAT. Despite these reforms, however, relatively high tax rates for some firms and sectors continue to coexist with pervasive exemptions. The result is a patchwork tax system and low revenues. How, asks Hélène Poirson in a new IMF Working Paper, can India raise its tax revenues to address its critical infrastructure and social needs without compromising growth? The answer may lie, she says, in closing gaps in the tax base and removing tax-induced distortions to savings and investment decisions.
India’s ratio of tax revenue to GDP is low by international standards. This is partly due to extensive exemptions, which also cause the burden of taxation to fall disproportionately on some sectors. High tax rates affect the business climate and may have contributed to the growth of the country’s “shadow economy,” which carries costs in terms of forgone tax receipts and lower productivity growth.
Since 1991, the Indian authorities have undertaken a series of tax reforms, the main thrust of which has been to lower statutory rates and broaden the tax base. While these reforms have succeeded in boosting India’s openness—through large tariff reductions—and lifting the share of direct taxes in total revenue, the overall ratio of tax revenue to GDP has not risen significantly. India is left facing familiar but difficult choices. Years of large fiscal deficits have left the government with a heavy debt burden, and the government has increasingly been competing with the private sector, recently booming, for resources. At the same time, growing infrastructure constraints and critical social needs require higher government spending.
High and low
What should India do? Further tax reform has the potential to boost revenue and support continued rapid economic growth. After declining to below 14 percent of GDP in 2001-02, India’s general government tax revenue rebounded to 16¾ percent of GDP in 2005-06 (see chart). Revenues declined during the 1990s as major tax reforms were implemented. Direct tax revenues increased, but indirect tax collections declined, mainly because of tariff reductions. Recent reforms—namely, the addition of new services to the tax base, the introduction of a state-level VAT in 2005, and a modernized tax administration—helped reverse the decline in revenues. The tax take in India now exceeds the average for other Asian emerging countries by 3¾ percentage points of GDP but is 3½ percentage points below the average for all emerging countries.
To assess the effective burden of taxation in India on different categories of income and consumption, the study calculated the average effective tax rate (AETR). This standard indicator summarizes various tax effects, including statutory tax rates, the effective tax base (taking into account tax evasion, exemptions, and the extent of informal activity), and the quality of tax administration. It is measured as the ratio of tax revenue to the notional tax base derived from national accounts.
The results show that AETRs on labor and capital in India are broadly in line with those in other low-income countries but well below AETRs in the more mature emerging markets in Asia. The latter is attributable partly to the relatively narrow taxpayer base, the absence of social security and associated payroll taxes, pervasive tax incentives, low personal capital gains taxes, and a large informal sector. In contrast, India’s AETR on consumption is broadly in line with that in other Asian countries, despite a tax base that excludes many services.
Low AETRs on capital and labor, combined with relatively high statutory rates, reflect a tax system that is not very effective in raising revenue. For example, a 35.9 percent corporate income tax rate in India in 2003 generated revenue of 2.3 percent of GDP: Singapore raised 3½ times that revenue with a rate of just 22 percent, and Chile raised twice that revenue with a rate of 17 percent. These results suggest ample room to increase AETRs in India without raising rates and, thus, without hampering competitiveness.
Openness and tax revenue
After the 1990s tax reforms, revenue from direct taxes rose while revenue from indirect taxes fell mainly because of declining tarrifs.
Citation: 35, 15; 10.5089/9781451968507.023.A013
Data: Indian authorities and IMF staff projections.
Following three years of above-trend growth in GDP, India’s investment rate increased to 31¾ percent of GDP in 2005–06. This is similar to investment levels in Korea, Thailand, and Vietnam, but well below that of China (40 percent of GDP). Successive governments in India have lowered corporate and personal tax rates since 1993 to boost saving and investment. However, the corporate tax rate remains high, depressing investment by raising the required pretax rate of return. Moreover, interest deductibility tends to favor finance through debt over equity or retained earnings, potentially leading to higher insolvency risks and discrimination against small companies that face difficulty borrowing. Other tax distortions include the widespread use of rebates, exemptions, and special regimes for specific sectors and regions.
Cross-country studies confirm a negative relationship between the tax burden (tax-to-GDP ratio) and growth across advanced economies, but find no significant association in low- and middle-income countries. In contrast, firm-level empirical studies and simulation results support the view that a high marginal effective tax rate on corporations negatively affects growth.
How does the Indian income tax code affect incentives to invest? To investigate this, Poirson calculated two summary indicators, the marginal effective tax wedge between the pre- and post-tax returns on capital, and the marginal effective tax rates, defined as the ratio of the marginal effective tax wedge to the real required pretax rate of return. The two indicators incorporate not only the corporate income but also personal tax provisions, as well as depreciation allowances and the inventory valuation method. Both indicators measure the potential cost of taxation to investors and are comparable across countries.
Focusing first on the marginal tax burden at the firm level (ignoring any personal tax rates), the estimates show that corporations in India that have only limited access to debt financing, particularly smaller firms, face a high marginal tax burden. Reflecting the relatively high statutory corporate income tax rate, India’s marginal effective tax rate for investments financed by equity or retained earnings is nearly 33 percent (as of 2004), compared with an average of 22 percent in industrial countries.
Poirson also estimates the overall marginal tax wedge on capital, taking personal taxes into account. The results suggest that the tax wedge in India, at 1.4 percent, is slightly below the industrial country average, reflecting low personal taxes. However, tax-induced distortions tend to be high. Firms that rely on internal financing are penalized by a marginal tax wedge of 2.6 percent, almost one-third higher than the average in industrial countries. Equity financing is also penalized, although the tax wedge on equity-financed investments of 2½ percent is one-fifth lower than the industrial country average, reflecting lower taxes on dividend and capital income. In contrast, debt financing enjoys a negative tax wedge of 0.2 percent in India, compared with a positive industrial country average of 1 percent.
The wide coverage of tax incentives in India also means that the tax wedge varies greatly across sectors and regions. For example, the study estimates that the tax wedge for a firm that benefits from a corporate tax exemption is less than one-third that of a firm that does not enjoy a tax holiday.
Further reforms needed
A number of measures could help India raise additional revenue over time while generating a tax system that is less distortionary and, arguably, fairer. Many of the options are part of the government’s 2004 road map for fiscal consolidation. Key steps could include building on recent success in introducing the state-level VAT to create a comprehensive national goods and services tax (GST). International experience suggests that a GST would help secure gains in economic efficiency and boost investment and exports while generating revenue gains in excess of 1 percent of GDP. Broadening the tax base by lifting exemptions, expanding the taxpayer net, and increasing reliance on information technology to improve tax administration and compliance would also help improve revenue productivity and, in the case of exemptions, help reduce tax-induced distortions.
The study suggests that other 2004 measures—including the elimination of the corporate income tax surcharge and the dividend distribution tax—would decrease the marginal tax wedge by 0.2 percent of GDP and attenuate distortions. However, firms that rely on nondebt financing would be penalized. To address this and mitigate potentially excessive reliance on debt finance, India should consider additional reforms. These include limiting the deductibility of interest to a percentage of net taxable income, limiting debt for the purposes of income tax, limiting interest to a referential rate, and, introducing an allowance for corporate equity.
IMF Asia and Pacific Department
This article is based on IMF Working Paper No. 06/93, “The Tax System in India: Could Reform Spur Growth?” by Hélène Poirson. Copies are available for $15.00 each from IMF Publication Services. Please see page 240 for ordering details. The full text is also available on the IMF’s website (www.imf.org).