It is important the tax regime is designed in such a way that it does not become a source of distortion in the market or result in market failures.
The tax laws should be such that they raise a given amount of revenue in an efficient, effective and equitable manner.
The modern tax systems comprise of very broad-based taxes on income and consumption, levied at uniform and moderate rates. In India, taxes on both income and consumption fall far short of this ideal. The base is narrow and the rates very high. In the case of consumption taxes, the constitutional division of powers between the Centre and the states is such that neither can levy a tax on the comprehensive base of consumption of all goods and services.
While income tax can be levied by the Centre on a reasonably comprehensive base, it is not being done so because of special provisions catering to multiple, social, political and economic objectives and the vested interests of different segments of population. In the process, the tax system has become highly inefficient, comes in the way of optimum allocation of resources for production and consumption, and undermines investments and economic growth.
Compounding the ills of the bad design of these taxes, are the weaknesses of tax administration. In a recent review of the state of tax administration in India, the Tax Administration Reform Commission (TARC) has observed that "?the Indian tax administration is at its nadir. A fundamental and deep reform is urgently called for. There is no time to lose if investment is to be revived and its full potential reached, and an eventual tax revolt through capital flight or other direct protests is to be averted".
The state of Indian tax administration is also reflected in the World Bank Report on Doing Business in India, 2015 which ranks India at a dismal 156 out of 189 countries in terms of ease of paying taxes.
Rightfully, the governments have embarked on the reform of the tax system and there have been extensive debates surrounding the reforms. Two landmark reforms are the Goods and Services Tax (GST) and the Direct Taxes Code (DTC). GST would indeed be the most important initiative in the fiscal history of India. The ultimate objective of the GST reform is to replace multiple indirect taxes at the Centre and state levels by a single tax (GST), levied on a comprehensive base of all goods and services at a moderate tax rate. A vision of this reform is provided in the report of the 13th Finance Commission which outlines the design of a flawless GST levied at a moderate tax rate of 12 per cent (combined Centre and states tax rates).
Unfortunately, the states have been reluctant to endorse this flawless GST for various social and political reasons. The model that is being talked about will have some important exclusions from the tax base (e.g. real property, alcohol and petroleum). The states have also proposed tax to be levied at multiple rates - a lower rate for basic necessities and higher rate for other goods and services.
International evidence suggests that such deviations in the design of GST are neither economically desirable nor effective in achieving the objectives that they are designed to serve. For example, a recent OECD report points out that the exemptions and lower tax rates under VAT(value-added tax)/ GST, while designed to help those in the lower-income brackets, benefit disproportionately those in the higher-income brackets.
The governments are considering the revenue neutral rates to be as high as 27 per cent. No country in the world has been able to successfully implement a tax at such a high rate. More importantly, application of such a high tax rate to the service sector would be highly detrimental to the sector, which has been the engine of growth for India. Rather than contributing to higher investments and economic growth, a tax at these rates would lock us back at a Hindu growth rate of 4 per cent.
Pending the GST implementation, the states are pursuing tax policies that are immensely detrimental to the economy. For instance, Punjab has converted its VAT on most consumer goods from a multi-point tax on the full supply chain to a tax at the first point of sale. Uttar Pradesh has announced that for many transactions the VAT, rather than being collected and remitted by the vendor, will be deducted from the price by the customer and remitted directly to the government. Many states, most notably Tamil Nadu, Karnataka and Gujarat, are denying the credit for the tax paid on investments and other production inputs.
Most of the reform proposals in the DTC have been modified to such an extent that what is left is only a little different from the status quo and amounts to little more than re-wording of the same provisions. Rather than proceeding with this package, there is a need to go back to the drawing board and redesign the direct tax system so that it has a broad base and moderate tax rate of around 25 per cent. Also, in the global economy of today, the Indian tax system should be fully aligned with that of our trading partners.
On the tax administration front, TARC has provided an excellent diagnosis of the ills of the current tax administration and made many thoughtful recommendations. It emphasises that in modern tax jurisdictions, the goal of tax administration is not to maximise revenue but to maximise voluntary compliance and minimise compliance gaps. The current practice of blind pursuit of revenue targets has an adverse impact on tax officer equilibrium and leads to harassment of taxpayers. The TARC Report calls for all processes to be modernised to the point of making them 'digital by default'. Other feature that needs attention is the minimisation of tax disputes. The growing volume of tax disputes in India has earned the tax administration the label of "tax terrorism" and has given India a bad name in jurisdictions across the world. This has been the single most important factor contributing to the downturn in investments and economic growth.
The new government has appropriately provided a new direction to tax reforms in India and revived the hopes of Indian economy resuming its journey on the high growth trajectory. The reform of both direct and indirect taxes and the tax administration is fundamental to achieving these objectives of the government.
Satya Poddar is Tax Partner, Policy Advisory Group, EY (formerly Ernst & Young). An expert on goods and services tax (GST), which he understood threadbare while helping the Canadian Ministry of Finance implement it, Poddar is often the go-to man even for senior tax department bureaucrats on taxation matters. He serves as a tax expert with the World Bank and International Monetary Fund.