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ANNEX: Data Adjustments and Econometric Methodology
Prepared by Martin Mühleisen.
The Tax Reforms Committee was chaired by Prof. Raja Chelliah. It submitted its interim report to the government in 1991, with final reports in 1992 and 1993.
States have the constitutional prerogative to levy taxes on a range of activities, including agriculture, retail sales, and certain services. For a discussion of reforms and revenue performance at the state level, see Chapter III of India—Selected Issues (IMF Staff Country Report No. 97/74, September 1997).
The Modvat (a synonym for the current central excise tax) was introduced to overcome the cascading nature of the old excise tax and to prepare for a general VAT. However, the Modvat is largely limited to the production stage, with retail sales being taxed by the states.
The estimated income tax and an earlier flat tax scheme have generated little revenue. These taxes initially had a presumptive element (taxable income for retail traders was fixed at 7 percent of turnover), but this element was dropped in 1993.
There are 500,000 income tax cases under litigation, and around 100,000 cases related to indirect taxes. The gross amount of taxes under dispute is Rs 540 billion (4 percent of GDP).
The 1998/99 budget restricted Modvat credits to 95 percent of duty paid on inputs, partly to offset revenue losses through fraudulent claims.
A detailed discussion of tariff reforms and trade liberalization is contained in Chapter IV of India—Selected Issues (IMF Staff Country Report No. 97/74, September 1997).
Average tariff rates are based on 1992/93 import weights. The tariff collection rate (customs revenue divided by customs imports) includes special customs duties and a few other items but should move broadly in line with average tariffs. However, since 1991, a large number of items were moved off the restricted import list and have typically become subject to the maximum tariff. This process, together with a phasing-out of some end-use exemptions, has helped limit the decline in the tariff collection rate.
Economic reforms since 1991 have led to efficiency gains and a subsequent increase in growth rates (Chopra et al. 1995). There has been no study that attributed productivity growth to individual components of the reform program. Recent cross-country studies, however, point to a generally positive impact of fiscal reforms on growth (Gerson 1998).
For example, there are tariff incentives for the import of capital goods, provided the importer accepts the obligation to export goods of at least four times the import value of the capital good (the so-called EPCG scheme). Owing to a lack of controls, this incentive is frequently misused to import capital goods at low duty rates.
There are indications that the customs equation is not co-integrated (see Annex). However, the estimated elasticities have been broadly consistent with results from the 2SLS approach.
The search extended to variables that could have either direct or indirect effects on tax revenue (e.g., growth, inflation, and financial variables), and also included other model specifications (e.g., two-stage least squares).
The error-correction coefficient for corporate tax revenue is larger than one, which could have economic reasons (e.g., changes in the adjustment process due to structural breaks) but would warrant further analysis.
A high ratio of external debt to GDP creates pressure to generate revenues for debt servicing. India’s external debt has been well managed in the 1990s, and its external debt ratio was relatively low at 25 percent in 1997/98.
This result needs to be qualified in two respects. First, state and local taxes in India account for about 6 percent of GDP (see Table I.1) which is higher than in many other developing countries. A comparison of central government revenues therefore does not fully reflect India’s revenue position. Second, however, official GDP estimates in India are widely believed to under-report economic activity by a factor of 20 percent or more. According to such estimates, central government tax revenue could be as low as 8–8½ percent of GDP, and total public sector tax revenue would be around 12½ percent of GDP.
India’s tax rate on foreign companies is 48 percent, with other countries either taxing foreign companies at the same rate as domestic companies, or at a lower rate (Indonesia).
Under the current presumptive filing scheme, persons who fulfill one out of six wealth indicators (ownership of a house, car, telephone, credit card, or club membership; foreign travel) are required to file income tax declarations. This includes, e.g., many elderly people who have no taxable income.
In recent years, estimates for the revenue loss from tax cuts have frequently included offsetting revenue increases resulting from improved compliance and stronger collection efforts. Such effects would lead to higher tax elasticity and should not be included in M; however, the budget speech usually gives estimates for the direct loss caused by tax measures.
All variables included in the analysis have been found integrated of order one, using a Phillips-Perron test with critical values adjusted to allow for structural breaks.
There are no critical test variables for cointegration with imposed structural breaks in the literature. However, the critical value for the cointegration test should lie between the standard Phillips-Ouliaris values and those presented by Gregory and Hansen (1996) who tested for cointegration with unknown structural breaks. This would suggest a range between −3.07 and −4.68 at the 10 percent level of significance. Since the error correction term is significant in all short-term models except for the customs equation, a level around −3.30 appears likely.