THE DETOX: 12 Steps To Fix India’s Economy – A New Monthly Series
The dysfunctional tax regime has become an albatross that is strangling our economy
By Jaithirth Rao
FOR A country to have a steady growth rate, for it to become prosperous, for this prosperity to be widely disseminated, it needs a predictable, non-rapacious tax system. Kautilya would have agreed with this sentiment. Todar Mal would have emphatically endorsed this view. All practitioners of the 19th century discipline of Public Finance (now unfortunately subsumed by the vaporous non-discipline of Macroeconomics) would have understood the importance of a sensible tax system. The first maxim in classic Public Finance was that “the goose that lays the golden egg must not be killed — it should be encouraged to lay more golden eggs”. Simply speaking, there cannot be any tax revenues for the sovereign unless there is wealth being created by citizens. Therefore, the first condition is to have an environment where people engage in productive activities and create wealth. Rapacious taxation takes away the incentive for legitimate wealth creation. In the old days, if a king increased taxes too much, law-abiding peasants and merchants simply migrated to the next kingdom. This happens even today. High tax rates encourage talented people to seek their fortunes elsewhere, in environments where they can keep a larger share of their income and not have the wealth they create expropriated by ruinous taxes.
The other principle of taxation that Kautilya would have approved of is “predictability”. If a monarch decides to suddenly impose fresh taxes on activities that were earlier untaxed or to increase tax rates arbitrarily, even whimsically, it is a signal to citizens that the sovereign concerned is “mad”. To live in the kingdom of an insane ruler is to submit oneself to the caprices of a lunatic. One more recurring issue with respect to taxation is the role of the tax collector. History is replete with instances of cruel tax collectors driving citizens to rebellion. The Evangelists who wrote the four Gospels of the New Testament of the Bible make it quite clear that the ordinary people of Judea hated the tax collectors of the Roman empire. Tax collectors, more often than not, exceed the instructions of the sovereign and are frequently known to alienate whole populations. That is why the great emperor Akbar was concerned that his tax collectors, under Todar Mal’s supervision, behave in a humane manner.
Most economist agree that one of the reasons India has not been able to imitate East Asian countries and prosper has been the dysfunctional tax regime. Our tax system and tax administration inherited dubious legacies to start with, and instead of making it more rational and sensible, we have progressively made them worse. Today, it has become an albatross that is strangling our economy.
The insidious legacy we inherited from our erstwhile British masters was an excessive reliance on indirect taxes
The insidious legacy we inherited from our erstwhile British imperial masters was an excessive reliance on indirect taxes. As any economist will tell you, indirect taxes are often regressive and hurt the poor most. We compounded our problems by fostering a massive distrust of all foreign trade, particularly imports. In the first 45 years of our history, we kept on jacking up customs duties. We had mind-boggling duties of 140 percent and 200 percent in several cases. We added to our woes by imposing outright bans on several imports. At best, all this benefited a few domestic producers but hurt the citizens at large. No wonder that for many years, smuggling became one of the biggest business activities in India. By raising the cost of industrial products, we shifted the terms of trade against our farmers and hurt them. Rather than fix the primary problem, we tried to achieve one more sub-optimal solution by providing subsidies to farmers, a development that still haunts us. To this day, India has one of the highest rates of import duties in the world, although the situation has vastly improved after the liberalisation under PV Narasimha Rao. We also have absurd internal duties like Octroi, which are not just inefficient, but grossly anti-poor. Any entrepreneur engaged in business in India will tell you about the harassment he or she faces from the fearsome inspectors of the Customs, Excise, Sales Tax and Octroi departments. Goods and Services Tax (GST) is an attempt to simplify this horrendous system by having a national Sales Tax with offsetting credits for earlier payments in the production process. This proposal is stuck in a limbo. We don’t need outsiders to persecute us. We are good at doing this to ourselves.
WHEN IT comes to Direct Taxes, our story is even more pathetic. We should have gone for a low rate that remains unchanged for years and decades and allowed taxpayers to pay more not by raising rates but by their getting richer. We started on a bad footing. In 1946, Liaquat Ali Khanas the finance minister of prepartition India imposed burdens on businesses that, perhaps by design, were meant to cripple them. Unfortunately, our problems did not end there. Over the next three decades, we moved to 97 percent marginal income tax rates, high wealth tax rates, perfidious estate duties and the ridiculous super-profits tax, which punished efficiency. At the same time, we created a complex income tax code with many exemptions, “special” allowances and so on. Curiously, for a government that was supposed to be pro-employment, most of these goodies subsidised capital rather than labour. The noted civil servant IG Patel has recorded that at one point we listened to some foreign Leftist economist who was pushing for a “consumption” tax that existed nowhere else. In the end, we got a mixture of income and consumption taxes — the worst of both worlds. The hapless Indian citizen and businessman suffered as we pursued fashionable anti-growth strategies.
The combination of high indirect tax rates and higher direct tax rates resulted in massive tax evasion. Just like peasants in earlier times hid their produce from the eyes of the plundering Raja or Sultan, the citizens of India indulged in a tax revolt on a grand scale. A significant part of our economy to this day is ‘illegal’, ‘black’ or ‘underground’, away from the reach of the tax collector. We have converted otherwise have been law-abiding citizens into criminals and, of course, we have hurt our own fisc as this sector pays no taxes. A better job of cutting off one’s nose to spite one’s face could not have been accomplished.
While these anti-growth, anti-poor tax policies were piling up, we created, by administrative fiat, one of the worst features of our tax system. We completely forgot the principle of the “goose that lays the golden egg”. Rather than tell our tax collectors that it was their job to humanely and rationally collect taxes from citizens without destroying the creators of wealth, our government set ‘targets’ for its tax officials and signalled to them that it was perfectly in order for these officials to harass taxpayers by making inordinate, unreasonable and sometimes even illegal demands. Setting “tax collection targets” is both immoral and economically injurious. We now have a situation where tax officials send out notices and insist on garnering payments that they know will not stand the scrutiny of tribunals and courts. The official does not care if he or she is overruled after 10 years, as long as the current year’s targets are met and one’s promotion is assured. In this fundamentally tyrannical course of action, these tax officials receive support from the highest levels of the executive branch, where the finance minister’s concern is to meet the current year’s revenue projection, for who knows who will be the finance minister in 10 years’ time when the refunds are due?
A significant part of our economy to this day is ‘illegal’, ‘underground’ or ‘black’, away from the reach of the tax collector
As if the hapless Indian wealth creators were not burdened enough, we have added one more imponderable. Our government has given itself the supreme right to make as many whimsical, ad-hoc changes as it feels like. If you were to start a factory based on the assumption that your end product will have a 10 percent excise duty, nothing prevents the government from raising that to 40 percent, making your factory uneconomical and your investment a waste. And this change can be done and is almost always done by a casual stroke of the pen.
No sultan of antiquity has been as intrusive, rapacious and whimsical as the finance ministers of free India. Is it any wonder that our country remains among the poorest in the world? So many other countries that were as poor or poorer than us have surged past us and managed to give their people decent lives. Luckily for us, although we lost four-and-a-half decades (and what a loss that was; we might have been as rich as South Korea today if only we had not frittered away those precious decades), we have had a two-decade period where better sense has prevailed. Our duty rates are down, our direct tax rates are down — guess what incomes have risen, wealth has increased and the beneficiary has been the government with increased tax revenues. Verily, the goose, when allowed to thrive, does lay golden eggs.
But we are still not out of the woods. In the past decade, there has been a distinct effort to “go back” to the bad old days of TT Krishnamachari and Morarji Desai, let alone Liaquat. And our administrative system has seen inadequate reform. Businesses and entrepreneurs are not seen as valuable geese but as chickens whose feathers should be plucked. If we don’t change the incentives for our tax administrators, all our policy reforms will get us nowhere and that will become the justification for another round of rate increases and all its baneful consequences.
So where do we go from here?
1. We must continue to aggressively reduce our rates of duty and bring them on par with other emerging economies.
2. We must implement the GST with great urgency. We must eliminate atrocious levies like Octroi today, not tomorrow, not in five years.
3. We must seriously consider moving away from distorting subsidisation of capital to conscious encouragement of full-time permanent employment of our citizens. Why not provide 200 percent deduction to employers for Provident Fund payments, rather than tax credits for buying capital equipment?
4. We must NOT introduce new whimsical elements like GAAR in our Direct Taxes code. The Income Tax Act of 1961 may not be perfect. But over the years, so many of the contentious issues surrounding it have been settled by Supreme Court judgments. This makes for predictable business planning. Introducing a whole new element of whimsicality will simply increase litigations. It will take years for legal clarity to emerge. In the meantime, investors — domestic and foreign — will shy away and low investment will doom any prospects we have for creating prosperity.
5. The incentive structure for tax officials MUST be changed. Their job is NOT to achieve targets. Their job is to implement the laws of the land fairly and humanely. Revenues will come when Indians grow richer, not by harassing those who are creating wealth. In fact, willful or whimsical harassment should be penalised.
6. The government must unilaterally announce that it will not appeal any tax case that it loses at the level of a tribunal. Right now, every tax official routinely appeals even forlorn cases simply because he or she may be accused of having been bought off by the assessee if no appeal is preferred. This is another perverse incentive that is clogging up our court system and increasing the levels of uncertainty in our economy.
7. The government must desist from ANY retrospective taxation. This is not to question its authority; only advocating a wise course and one that will reassure our citizens and citizens of other countries to invest in India and stay invested.
8. We must stop being ad-hoc, arbitrary and whimsical in our taxation at all costs. There is even a case for freezing all tax provisions and making no changes each year in February.
One of India’s foremost right-wing economic thinkers, Jaithirth Rao is founder and chairman of Value and Budget Housing Corporation, a company in the affordable housing space.