To understand the importance of direct taxes, one needs to look at how the rupee comes in. Look at the chart below for Tax revenue in India 2017-18..
Source: Budget Documents
If you look at the sources of revenue of the central government, 35% comes from direct taxes while 33% comes from indirect taxes. Obviously, any decision to enhance direct tax revenues will predicate on deepening and broadening the base of income tax and corporate taxes. That will be one of the main focus areas of this Union Budget 2018 as the government needs to tap into all possible sources of revenues to balance the budget better. Here are a few ways of going about the direct tax front and the measures to increase tax revenue. So, what could be the strategies to improve revenue collection?
Broaden the individual tax base in India..
Thanks to Jan Dhan, Aadhar and demonetization, the government finally has a good hang of how much tax each individual needs to pay. Currently, there are just a little over 6.4 crore tax payers in India. According to the data coming in from the demonetization exercise, there is the potential to add another 1.5 crore assessees to the list. Even if you assume that each of them pay an average tax of just Rs.40,000 per annum, it translates into Rs.60,000 crore of additional revenues. Thus using the combination of Jan Dhan, Aadhar and Mobile (JAM) and slicing the demonetization data will go a long way in broadening and deepening the tax base. Consider the chart below..
Source: Budget Documents
The ratio of direct taxes to GDP peaked in 2007-08 and has been tepid ever since. The government had targets of raising the combined ratio of direct and indirect taxes to over 12% of GDP. The time to commence may be in this budget.
Bring Tax / GDP ratio to EM standards; and then to global standards..
The first attempt in this budget must be to at least bring the tax/GDP ratio in India to the level of emerging markets. Consider the following chart below..
As can be seen from the chart above, the ratio of total tax / GDP in India is far lower than other small nations. The ratio will be much lower when we look at more robust economies. The first thing the government needs to do in Budget 2018 is to benchmark India’s tax/ GDP ratio to other countries and at least target a time-bound focus to reach 15% in the next 3 years time. In fact, the combination of Jan Dhan, Aadhar, and Mobile and demonetization data is the right launch pad for the Indian government to give a big boost to its direct tax collections, especially from individuals.
Improving the corporate tax rates..
The corporate tax rates represent a queer anomaly for the Indian tax system. On paper the tax rate stands at over 33% but the effective rate of tax that Indian corporates pay after considering the exemptions and rebates is just about 28%. That is because there are write-offs, then there are capital investment allowances, then there are backward area allowances and tribal area allowances. Above all, companies are permitted to use a different method of depreciation for accounting and a different method for tax purposes. While there is logic to this convolution, the fact of the matter is that it has made the taxes for corporates extremely confusing. The net result is that the effective tax is much lower and compliance is lacking.
Learning from the US example..
The US is probably the first nation in the world to attempt such a bold tax cut for corporates. It proposes to cut the effective tax rate for corporates from 39% to 21%. What Trump is betting on is that this will lead to a virtuous investment and capex cycle by US corporates which will enhance tax collections on a much higher base. So, what can India learn from the US example.
Currently, the Indian tax system is quite convoluted. The applicable tax rate is over 33% but the effective rate is just about 28%. Even this rate has gone up sharply from 24% recently due to the withdrawal of certain profit-linked exemptions. Additionally, there is a concessional rate of 25% for Indian corporates that have annual turnover below Rs.50 crore. This is a recipe for companies to split their business into smaller units like in the old SSI days. The best way would be to reduce the tax rate applicable to about 22-23% and get rid of all exemptions. Probably the SEZ exemption may still remain but the rest of them can be done away with. So the effective rate of tax will reduce, exemptions will be done away so tax compliance becomes easier and a larger base of companies can be brought under the tax bracket. That could be the big focus of the Union Budget 2018.