Ajai Das Mehrotra
Pr. Chief Commissioner of Income Tax, Gujarat
Sh.Ajai Das Mehrotra, is an IRS officer of 1984 batch and is currently posted as Principal Chief Commissioner of Income Tax, Gujrat. He had worked extensively in the field of Assessment, Investigation and other direct taxation fields. He had attended 49th National Defence College course and was awarded Commandant’s Book Prize for his thesis on “Post-Liberalization Direct Tax Reforms in India”
This thesis was written in 2009 and subsequently, Government has brought in many changes in Tax administration. Brief of the paper, duly updated, has been reproduced here The thesis titled “Post liberalization Direct Tax Reforms in India” was submitted in 2009 by the author for the award of M. Phil. Degree from Defence and Strategic Studies under the University of Madras. Statistics appearing in the present article have been updated for the beneﬁt of the readers. Full text (84 pages) of this paper, under the same heading is avail able on the departmental web site at the following link –
In 1991, in reaction to a severe macro economic crisis involving high fiscal deficit and depleted foreign exchange reserve, India approached the World Bank for a ‘structural adjustment’ loan. The structural adjustment programmes supported by the World Bank institutions, while disbursing loans, began by encouraging reform in trade policy. The emphasis gradually shifted to fiscal issues, in response to growing recognition that inappropriate and unsustainable expenditure and revenue policies are, in many instances, the major cause of disappointing economic performance. Polak’s Model1, followed by IMF, asserted that the external gap (current account balance) is a reflection of the internal gap between revenue and expenditure. Structural adjustment programmes, therefore, became more concerned with mobilising revenue through improved taxation and better pricing of public services. Tax reform became an essential component of strategy of structural adjustment in developing countries, as it was felt that “existing tax systems of many developing countries are distortionary and contribute to a host of economic problems, including production inefficiency, capital flight, and fiscal and balance of payments disequilibria”.2
The trend of tax reforms in the developed world in the eighties began to be reflected in Bank-Fund advice on tax reforms, placing emphasis on uniform taxation through an “explicit recognition that gains in economic efficiency, horizontal equity, and administrative simplicity that stem from uniform taxation outweigh any vertical equity losses.”3
Let us first look into the background situations existing in the decade, 1990-2000. Indian Economic Crisis: Faced with rising inflation (12.1%), huge fiscal deficit and balance of payment crisis in mid-1991, India’s new government introduced a fairly comprehensive policy reform package-with currency devaluation as its centre piece. A sudden drying up of inward remittances, higher oil import bill due to the Gulf-war, collapse of the Soviet economy (then India’s largest trading partner) and rapidly advancing Chinese economy with a greater use of market co-ordination formed the international background for initiating these policy changes. On the domestic front, the political instability (India had three Prime Ministers from three different political parties in the preceding 18-month period) had accentuated the economic troubles as critical decisions got postponed and fiscal discipline loosened. In dire need for funds, the Finance Minister, in letter dated 11.11.1991, highlighted some of the reform measures taken and wrote to the President, World Bank that “the effectiveness of these measures in bringing about the desired structural adjustments in the economy while maintaining the momentum of growth depends critically on the availability of adequate external finance. Accordingly, we are requesting a Structural Adjustment Loan / Credit from the World Bank”.4 Key ingredients of economic policy followed by India in pre-1991 period were:
Some of these key ingredients were shelved or revised when economy was opened-up and liberalized, as part of structural adjustment programme, in the period 1991 onwards. It included loosening of quota-permit raj, shrinking of public sector, lowering tariff barriers, policy of emphasis on export generation rather than import substitution, current account convertibility and ‘managed’ float of rupee. Tax reforms were part of these changes.
The Indian reforms tried to consciously fashion the new policy as close to the ‘Washington consensus’5 as permitted by domestic conditions and advocated by the International Monetary Fund and the World Bank, shown below:-
More efficient revenue mobilisation can fund needed public goods and services and help cut fiscal imbalances as well as promote investment and growth by reducing the adverse allocational effects of the tax system.
WORLD BANK’S ADVICE ON DIRECT TAXES
The Bank-Fund advice on income tax reforms reflected the world trend. The tax rates have reduced globally. The peak Personal Income Tax rate in OECD countries reduced from average of 54.9% in 1986 to 37.6% in 20026. Studies on tax reforms in Chile and Uruguay (Harberger, 1989), Colombia (McLure, 1989), Indonesia (Gillis, 1989) and Jamaica (Bahl, 1989), amongst others see a trend of ‘base broadening and rate flattening”. Abed (1998:21) notes lowering of top marginal income/corporate tax rates in reforms carried out in the 1990s in Bangladesh, Benin, Bolivia, Kenya and Uganda.
TAXATION OF INCOME: SOME CONCEPTS
In The Wealth of the Nations (1776), Adam Smith proposed that a good tax system:
These principles still hold good. Taxation fulfils many of these characteristics. High rate of taxes generally discourage saving and investment. “The discouragement of investment, however, is less severe than may appear because the tax often reduces the net loss suffered on an unsuccessful investment as well as the net profit realised on a successful one.7 Overall, income taxes have much less distortionary effect than most excise, import and sales taxes.
Adequacy and yield-
Taxes on income yields adequate and substantial revenue in many developed countries. In India, it is an important source of revenue.
Ability to Pay- In majority of countries, individual income taxes are generally levied under ‘global’ system. It is also followed in India.the poor are kept out by a threshold limit. Most Economists view income tax as best form of taxation because it reflects the taxpayers’ ability to pay, as income is universally regarded as the best single index of economic power. Horizontal equity implies that those placed in similar economic circumstances should be treated the same. Vertical equity concept relates to use of progressively higher rates of taxes (tax the richer heavily than the poor) to attain goal of reduction of income equality. However, companies are taxed at uniform rate, as equity is concerned with people and not with organizations.
Economic Neutrality and Resource Allocation Decisions-The economic neutrality or efficiency is a measure of effect of a tax on relative prices and economic decisions made by consumers and producers. An economically neutral or efficient tax should not upset the pattern of production, trade, consumption, savings and investments. Individual income taxes have relatively little effect on economic choices.
Visibility: Income tax is highly visible. Its visibility can be reduced by provision of tax deduction at source (TDS) or pay-as-you-earn (PAYE). Most of the tax is actually collected and therefore, its visibility is effectively reduced.
Collection cost: By keeping threshold higher the cost of collection can be kept low. In India, the cost of collection of IT is presently only 0.54% of total tax collected.
Political acceptability: Income tax, in some form or the other, has been in existence for more than 150 years and has gained political acceptability. However, there is no tax on agricultural income in India and attempts to bring it have faced severe resistance indicating its poor political acceptability.
Administrative Capacity: A complex but well settled income tax law, with judicially interpreted phraseology, is in place in India. A system of TDS and advance tax payment is in place. However, weaknesses in administrative capacity are reflected by:
Relationship between Domestic and Foreign Tax Bases and Rates: A country is able to attract foreign capital and to retain domestic capital if it has a transparent, efficient, stable and moderate tax system. Large differences in tax rates between countries may lead to capital flight and transfer of profits from high-tax-rate to low-tax-rate country. While designing its tax system, a capital-importing country, like India, must take into account the tax regimes of capital-exporting countries as well as the advantages of its competitors, vying for the same foreign capital. Some countries have entered the competition for capital by lowering tax rates or by giving more promotional incentives than their competitors.
Tackling Influence of Inflation: Inflation is an implicit tax, as people with equivalent incomes, are left with lesser purchasing power. The government should attempt to insulate explicit taxes from the consequences of high inflation rates. In the case of personal income taxes, inflation can lead to bracket creep (people with lesser purchasing power are asked to pay taxes at the same rate) and to erosion of threshold allowances and deductions. The remedy is to link the nominal tax base with some inflation index (e.g., consumer price index), as has been attempted in Mexico and Turkey. In Chile, a comprehensive system of inflation indexation has been developed with a view to reduce such distortions. It is suggested that instead of ‘patches’ or parts of tax system indexed to inflation, the entire tax system should be indexed to inflation.
SIMPLIFICATION OF TAX LAWS
A number of changes were introduced to simplify some of the calculations attendant to filing of return:
The donor-based Gift Tax Act was withdrawn but gifts from non-relatives were made taxable in the hands of the donees in the Income Tax Act (s 56 (vi)) wef 30.09.98. Business re-organisation was made tax-neutral wef 1999-00. This helped in unleashing of mergers and demergers making business more efficient.
EFFECT OF REFORMS ON REVENUE COLLECTION
The study examines the effect of reforms on tax collections, savings and investments in the period 1991 to 2009.
Normally revenue collection should go down with lowering of tax rates. The share of direct taxes in gross tax revenue has gone up from 23% to 55% in the period 1991-92 to 2008-09. In the corresponding period, the share of indirect taxes in gross tax revenue went down from 77% to 45%, indicating structural shift in the composition of revenue. This was a reflection of maturing of Indian economy, as economists prefer direct taxes – as they are more equitable and are linked to the tax payers’ ability to pay. The brunt of indirect taxes is also borne by the poor when they buy consumable products.
The all round improvement in direct tax collection with lowering of tax rates in India led to the conclusion that India is providing a textbook illustration of the ‘Laffer curve’10. India’s gamble of reducing tax rates, at a time when additional resources were required, has apparently paid off
The lowering of tax rate appears to have a positive correlation with revenue collection, domestic savings and domestic capital formation. It has also brought in a virtuous cycle of compliance, as more and more tax payers are joining the rosters of ITD. The number of taxpayers has risen more than five times from 70 lakhs in 1992-93″ to 3.67 crores in 2007-0812 and it has gone up to 6.92 crores in 2016-17 and expected at 7.41 crores in 2017-18, with Direct tax to GDP ratio at 5.98. (Source administrative Handbook 2019)
SHORTCOMINGS IN THE DIRECT TAX REFORMS AND THE WAY AHEAD
The World Bank publication, ‘Lessons in Tax Reform’ advises that tax preferences should be ‘limited in coverage and duration to cases in which market imperfections cannot be addressed more directly’13. The IMF also advises for ‘minimum recourse to tax incentive schemes’14. Chelliah Committee on Tax Reforms had advised Government of India that with lowering of tax rates, ‘several of the incentive provisions (should) be withdrawn’15. The TRC pointed out that “the use of the tax system for promoting such (non-revenue) objectives undermines the equity of the system, creates complication in administration and leads to all kinds of distortions and anomalies. For a thorough reform of the tax system towards simplicity and equity and substantial reduction of rates, it is absolutely necessary to eliminate all such incentives/concessions in the tax system except for the essential few.” Despite clear advice on the issue of reduction of tax preferences, Government of India did nothing to curtail tax preferences. In fact, tax preferences have increased over the years. The income tax law presently provides for exemptions and concessions for every conceivable activity with social appeal, ranging from sports to family planning, from exports to poultry farming, and so on. Many of these incentives are distributed as political largesse rather than for any sound economic reason. Sometimes it is also a manifestation of rent-seeking activity of ‘pressure groups’.
Most of the incentives were introduced in the Income Tax Act during high-tax-rate-regime to promote activities which were considered beneficial to social and economic development of the nation. Incentives to promote export and foreign exchange earnings were introduced to assist Indian companies to compete in global market. Incentives for investment in backward areas were introduced to promote balanced regional development. While these non-revenue goals are laudable in themselves, it is time to carry out a study to identify incentives which are effective and have actually led to achievement of these non-revenue objectives, and those which are not. The latter can be considered for curtailment/elimination. “Thus, in devising tax policies to meet economic and social objectives, potential gains must be weighed against the revenue and potential losses in efficiency that might be associated with these measures.”16 Curtailment of tax incentives has been part of tax reforms of Indonesia, Columbia and Jamaica17.
Once tax incentives are withdrawn substantially, Government can think of withdrawing minimum alternate tax, thus reducing the administrative burden of implementing this complex provision.
Taxation of agricultural income
Taxation of agricultural income is a state subject under the federal constitution of India and therefore the central government is not able to levy any tax on it. The state governments do not have the machinery to levy income tax on one activity alone. Thus, agricultural income largely goes untaxed. Non-levy of tax on agricultural sector is leading to following negative effects:
(a) Government is losing revenue,
(b) it is causing horizontal inequity and
(c) a number of non-agriculturists are showing agricultural income and avoiding payment of taxes.
Showing agricultural income has become an easy route for conversion of unaccounted business income to declared income without any tax burden.
During 1960’s and 1970’s, a number of committees were appointed, both at the Centre and State levels, to examine the issue of agricultural income taxation. This tax could not be imposed due to:
a) Political reason18
b) Difficulties in assessment of agricultural income. They arise from the nature of agricultural operations and the conceptual problems involved in distinguishing current from capital costs19.
c) Agriculture was generally considered as a subsistence activity.
For political reasons, agricultural sector could not be imposed with any substantial additional tax burden. This issue was altogether abandoned by both the governments and the researchers. The new Direct Taxes Code also does not propose to tax agricultural income.
Anti avoidance provision
The line between tax evasion and tax avoidance is getting thinner . A tax avoidance scheme is generally understood to be the one where “steps having no commercial purpose apart from the avoidance of a tax are inserted in a composite transaction made up of a pre-ordained series of transactions.”2° Tax laws of many countries like Singapore, Australia, New Zealand, UK, Malaysia, etc. now have anti-avoidance provisions. Similar law based on section 33 of the Singapore Income Tax Act, have already been adopted in India.
Reform of State and Local taxes
The Central Government has carried out co-ordinated reform of taxes falling in its jurisdiction. The State and Local governments still lag behind in the reform of taxes falling in their jurisdiction. This has indirectly effected collection of central taxes, e.g. high stamp duty (a local tax) on transfer of property still entices people to under-declare the cost of consideration of the property at the time of its sale, thus reducing capital gains payable on it. Similarly, high sales tax rates (a State level tax), lead to unaccounted sale which lead to under-declared profits and which in turn leads to lower collection of income tax. It is, therefore, imperative that a regime of moderate central taxes be accompanied by a regime of moderate state and local taxes. GST reforms have been subsequently introduced.
Reform of Tax Administration and Procedure
(a) Incentives facing tax administrators
The First CIAT general assembly in Panama in 1967 had declared that “tax administration is the key to tax policy”. Over the period of time it has been recognised that the way taxes are administered can make a difference between statutory’ and ‘effective’ taxation1. This led Jantscher (1990) to declare that “tax administration is tax policy”.
The tax department, being part of larger bureaucracy, is often required to conform to broader government policies in hiring, firing, compensation, and promotion. Tax economists and HR consultants, after study of tax administration in different countries, have stressed the role of proper financial compensation to tax administrators for success of any tax reform programme. Some countries, like Ghana, Uganda and Zambia have set up autonomous Revenue Boards, separate from the Civil Services, to overcome this problem. They had met with ‘considerable success’3. If tax administration is to be made effective, its wage policy must be revised. The IMF advises to have ‘fewer but better paid civil servants’. Higher salaries for tax administrators, within civil service, have been provided in many countries, including Argentina and Peru. While role of monetary reward in motivating an employee cannot be denied, it should not be over stressed. One should be able to recognise non-monetary rewards which can be offered to staff, like putting up photograph of the best employee, introducing best inspector to the Chief Commissioner, giving challenging job of ‘audit’ to better performers, etc.5
An effective reward should fulfil following three characteristics:
Differential treatment, whether in monetary or non-monetary terms, between good and bad performer does motivate and reinforce good performance. India’s present reform programme has totally overlooked this aspect of global trend of tax reform. If tax reforms are to have any sustained impact, incentives facing the tax administrators have to improve.
(b) Identification of ‘dead wood’ and ‘corrupt wood’
It is essential to identify the inefficient and corrupt officials and to suitably punish them. Punishment to bad performer should be as visible as reward to good performer. Tanzi and Pellechio (1997:277) advocate “higher salaries but less secure jobs for tax administrators”. The Tax Reform Committee has suggested three pronged strategy to deal with corruption :
(c) Reallocation of resources
“Traditional tax administrations generally use their personnel and resources poorly. Often, a large share of personnel is occupied with trivial, mechanical, and highly unproductive tasks, while useful tasks are starved for resources. The reason for such misallocation is that today’s allocation may reflect yesterday’s needs.” Some steps to free workforce from routine low productivity jobs are: mechanisation; tax collection through banks; setting appropriate threshold to take out cost-ineffective small cases; use of deterrent penalties to encourage voluntary compliance; self assessment; audit selection strategy and its secrecy7; presumptive tax on small taxpayers to take them out of procedurally long regular taxation, etc. The manpower so freed can then be redeployed in more productive areas, like audit, big taxpayers cell, ‘hunting’ for new assessees, etc. Similar attention should be paid for reallocation of financial resources.
(d) Privatisation of some functions of the tax department
Enforcement of tax laws and collection of taxes is a function which has to be performed by the state itself. However, Acuna (1992) suggests that some routine functions of the tax department can be considered for privatisation. As part of the reforms in India, work relating to Taxpayer Information Network (TIN) has been outsourced to National Securities Depository Limited (NSDL) and for PAN to UTI Limited.
(e) Allocation of adequate funds and their fungibility
Government has given more than necessary emphasis on reducing the cost of collection of direct taxes. The cost of collection was only 0.54% in FY 2007-08. One major reason is allocation of inadequate funds to run the tax office. The tax office is always short of such essential items as paper, printed stationary, etc. The visitors to tax office are not even provided with facility to sit while they wait for ‘hearing’ of their tax cases. The allocation of funds for upkeep of tax offices should improve. Further, the departmental heads should be allowed greater flexibility to use allocated funds. Subsequently, Aaykar Seva Kendras, ASK- have been set up all over the country.
(f) Training of staff
While quite adequate network exists for training of staff in tax matters, extension of training facilities in use of computers and in investigation of tax evasion cases is desirable. The Tax Reform Committee has suggested that senior officers of the tax departments should be given training in broader social aspects and economic consequences of taxation.
Tax Research Bureau and other pan-organisational facilities: The Tax Reform Committee and the Expert Group have both noticed lack of basic data for analysis of impact of existing and alternative tax provisions. The Expert Group (para 17, page 5) noticed that “No reliable information, even relating to the allowances claimed by large companies or by taxpayers according to their income range, the tax effect of various incentive provisions, like reliefs and savings in specified assets, the impact of depreciation rates or cause-wise analysis of appeals, is available.” In absence of such details, the reforms and changes in tax laws are more based on conjectures than sound analytical reasoning. The Tax Reform Committee had suggested setting up of a Tax Research Bureau consisting of economists, revenue officers, and tax practitioners and assisted by research assistants, to conduct research in matters of tax policy on a regular basis. Subsequently, it has been set up under DOR Establishment of such a bureau within or outside the tax department is imperative to ensure that changes to tax laws are made on sound analytical basis and not on perceived notions of bureaucrats/politicians. Similar pan-organisational institutions should be set up to support field staff in audit, investigation, legal representation of cases or to study practices relating to evasion of taxes.
A continuation of present efforts to simplify tax laws; to expand TDS coverage; to widen tax base and to increase scope of presumptive taxation, along with implementation of suggestions given in this chapter is likely to lead to improvement in both tax compliance and increase in revenue.
There is a need for adoption of a differential performance-based pay structure for tax administrators, with visible reward to performers and punishment to non-performers. It is suggested that some routine functions of tax department may be considered for privatisation to introduce a feeling of competition. The tax department should continuously analyse its utilisation of available human and financial resources, so as to put them to maximum use. This paper suggests some steps to free the workforce from routine low productivity tasks and their redeployment in more productive areas. The tax department should consider setting up of Tax Research Bureau and other pan-organisational facilities to continuously improve its working.
Tax reform does not happen on its own but has to be brought about. Tax reform has to be a continuous process. Collection from direct taxes in India has grown steadily. From 2008, direct tax collection has, overtaken collection from indirect taxes. However, there is scope for further improvement.
1 – Named after Jacques J Polak, an IMF economist, it is a macroeconomic monetary model developed in the IMF. It is the basis of conditionalities applied by IMF while giving credits.
2 – Shirazi and Shah, Tax Policy in Developing Countries, World Bank, Washington,1991,page xv.
3 – Ibid, page xvi.
4 – From the text of Finance Minister’s letter to the President, World Bank, reproduced in Uma Kapila, ed., Recent Developments in Indian Economy With Special Reference to Structural Reforms, Academic Foundation, Delhi, 1992, page 338.
5 – The term was coined by Williamson, 1989 to denote the package of policies advocated by the IMF and World Bank.
6 – Howell H Zee, Personal Income Tax Reform: Concepts, Issues, and Comparative Country Development, IMF Working Paper WP/05/87, International Monetary Fund, April, 2005, page 48.
7 – Evsey D. Domar and Richard A. Musgrave, Proportional Income Taxation and Risk Taking, Quaterly Journal of Economics, vol. 58 (1944), pp. 388-422, quoted in Goode, R. (1984:116).
8 – Normally, in taxation of business income, an allowance has to be provided for recovery of capital costs representing use of capital assets in the production process. This recovery has to be spread over number of years representing gradual depreciation in value of assets due to normal wear and tear and due to obsolescence.
9 – A lower flat rate was prescribed as under declaration of value of asset at the time of sale was leading to loss of revenue for the state and local government in the form of lower stamp duty and municipal taxes, respectively.
10 – Refers to a supposed relationship between economic activity and the rate of taxation which suggests that there is an optimum tax rate which maximizes revenue. Named after the American economist Arthur Laffer.
11 – Budget speech of Finance Minister for 1992-93, available at www.finmin.nic.in
12 – Administrative Handbook of ITD, 2009, page296
13 – World Bank, Lessons of Tax Reform,1991, page 58.
14 – Abed op cit page 10.
15 – Raja Chelliah, TRC Final Report, Part I, Ministry of Finance, New Delhi, page 11
16 – Shirazi and Shah, op cit, page xviii.
17 – World Bank, Lessons of Tax Reform, 1991, page 37.
18 – DN Dwivedi, op cit, page 47
19 – KN Raj, “Direct Taxation of Agriculture”, in Ed. Dwivedi, D.N., Readings in Indian Public Finance, Wiley Eastern Limited, New Delhi, 1973, page 51.
20 – Expert Group, Report to Simplify Income Tax Law, Taxmann, New Delhi, 1997,41.
21 – Vito Tanzi and A. Pellechio op cit, An ‘effective’ description of taxation is the one “based on economic reality, taking into account all the distortions brought about by tax evasion, tax avoidance, misapplication of laws, abuses on the part of tax officials, and so forth.” Page 274.
22 – Silvani and Baer (1997), Tanzi and Pellechio (1997), Schlemenson (1992), Chand and Moene (1997)
23 – Silvani and Baer, Designing a Tax Adninistration Reform Strategy, in Tax Notes International, 1997, page392
24 – A. Tait, IMF Advice on Fiscal Policy, Finance and Development, March 1990.
25 – According to World Development Report, 1994, such rewards in kind have been very successful in reform of state owned enterprises in Korea.
26 – Tanzi and Pellechio, op cit 1997, page 279.
27 – “ It is important that taxpayers believe that a larger percentage of taxpayers is audited than is actually the case (Tanzi and Pellechio, op cit 1997) . However, in India, Government routinely announces the crieria for selection of cases to prevent misuse by the tax administrators.
28 – LFR Acuna, Privatisation of Tax Administration, in Bird, R.M. and Jantscher, M.C.(ed.), Improving Tax Administration in Developing Countries, IMF, Washington, 1992