One of the stylised beliefs in India, and amongst some leading economic commentators both in India and abroad, is that our tax/GDP ratio is lower than what it “should” be. Many ills are laid at the door of this hypothesised low tax/GDP ratio. It is conjectured that we have a lower rate of investment, a higher fiscal deficit, and lower GDP growth — and all because the tax ratio is too low. There can be reasonable doubts about the presumed links, an issue on which I have relatively little to say. For the record, I have long argued that there is no empirical evidence to indicate a causal relationship between tax ratios or fiscal deficits and growth — or even a statistical relationship. There is, however, a well-established relationship between investment and growth.
Proceeding, there are three important fiscal variables in the economy — taxes, fiscal deficit, and debt. They are inter-related — lower tax revenue means higher fiscal deficit, for the same level of expenditures, and higher deficit means higher debt. All three, directly or indirectly, are assumed to affect growth and/or inflation. The relationships are complicated, and have provided grist for a number of PhDs, with many more to come. Our goal in this article is to look at the first of the trinity — the tax/GDP ratio (hereafter Xtax). We look at Xtax in an uncomplicated way, just facts, and interpret the evidence.
Two common observations on Xtax for India — first, it is low at around 10-11 per cent of GDP and it has stayed at close to that level for the last 20 years. In 2019, it hit a decade low of 10 per cent of GDP, the same as in 2014. Second, in comparison with our peers, it is much lower. Hence, logic dictates that we should strive to increase Xtax.
But which country should we compare India with? A common observation (surprisingly also offered by economic experts) is to look at the tax-GDP ratio in G20 countries. This is the beginning of a set of misinterpretations committed either knowingly, or unknowingly. Because simple logic dictates that tax collected is a function of the average level of per capita income. Per capita income in the G20 varies from around $2,100 (India) to around $65,000 (US). But before going “there”, there is a more fundamental issue that needs to be resolved. The 10-11 per cent figure for India is the tax/GDP ratio for taxes administered at the central level. Taxes in India, as in many other large, especially federal, countries, are collected at both a federal and state level. And many economies have local (municipal) taxes as well. The tax collected is the sum of all these taxes. That is the Xtax that needs comparison.
Until now, collecting such disaggregated data for a large set of countries was, well, impossible. In a recent web publication, the IMF has come to the rescue and for which kudos are due. On their World Revenue Longitudinal Data set (https://data.imf.org/?sk=77413f1d-1525-450a-a23a-47aeed40fe78) data are presented for all countries, from 1990-2019.
In this pre-pandemic year, among G20 economies, India’s tax-GDP (Xtax) ratio of 16.7 per cent was higher than that of China (15.9 per cent), Mexico (14.1 per cent), Indonesia (11.0 per cent), Saudi Arabia (5.9 per cent) and Turkey (15.9 per cent). While reassuring, such a simple head-to-head comparison is not very meaningful. A more informative indicator of whether a country is taxing too much or too little in comparison with others is to look at the tax-GDP ratio adjusted for PPP per capita income (and excluding resource-rich economies like Russia and Saudi Arabia and countries with population less than 3 million). Prediction via a simple regression of Xtax on log PPP per capita GDP can yield one estimate of the tax gap — the difference between actual and actual adjusted for level of income.
Table 1 reports the averages for 104 countries for the period 2011-2019. The world average tax gap is -1.3 per cent; India is +1.2 per cent for the nine years 2011-2019. So, India’s tax GDP ratio averages 2.5 percentage points more than an average economy. Among 70 Emerging economies (excluding AEs and countries belonging to the former Soviet Union), India’s rank is 20 — Xtax in India is higher than 50 peers on a systematic basis. Zilch evidence, therefore, that India’s tax/GDP ratio is too low. For every year for which data are available 1990-2019, India has had a positive tax gap — there is little evidence that a higher tax/GDP ratio helps growth.
But this is all before the tax collection revolution post-2019 (a structural change?), a subject matter to which we now turn.
Corporate tax cut 2019: For years, the advocacy in India was to increase revenue from corporate tax (one of three major components of tax revenue, the other being income and indirect taxes). The slogan: India Xrat was low, so raise corporate and income tax rates. “Because the rich should pay more taxes”; because inequality was increasing, and high, and because such higher taxation would lower the fiscal deficit and increase growth. A small minority had argued the opposite — that higher corporate tax rates stifle investment, increase tax un-compliance, and lower growth.
In a series of articles starting with ‘Maximise revenue, minimise tax’ (IE, July 13, 2019) Karan Bhasin and I argued against the heightened Indian wisdom. We argued that to increase tax revenue, we needed to decrease tax rates. (Incidentally, I had also argued that demonetisation would have a very positive effect on tax compliance a week after November 8, 2016!) We were dubbed Laffer curve groupies and faced criticism (and ridicule!) from more knowledgeable “experts” who said that empirical evidence around the world (for example, the US) meant that if tax rates were lowered, revenues would decline, the fisc would increase, as would inequality. A triple whammy that is best avoided.
In September 2019, Finance Minister Nirmala Sitharaman, going well against Indian established conventional wisdom, lowered the corporate tax rate by around 10 percentage points. This was one of the largest corporate tax cuts in world history. Unfortunately, the pandemic struck the world a few months later and disrupted world economies. However, now, three years later, we can assess the efficacy (or not) of this bold experiment in Modi 2.0. For the three months April-June 2022, corporate tax revenues, y-o-y, are up 30 per cent. Using fiscal 2019-20 as a base, corporate tax revenue has increased by 66 per cent, GDP by 33 per cent — an average tax buoyancy of 2.0 over three years. The previous largest tax buoyancy was in 2006-7 when the world was buoyant — and this was when the world was Covid-depressed! Tentatively, the tax-GDP ratio in the fiscal year 2022-23 will average over 18 per cent in India, a level close to Japan and the US.
What the data conclusively show is that the debate on the Indian economy should shift away from simplistic notions (borrowed from the West?) of the tax-GDP ratio being low in India. The debate should shift to expenditures, and quality of expenditures (and perhaps to reform of the direct tax code). In this regard, PM Modi’s suggestion that freebies be critically examined is most timely and welcome.
The writer is executive director, IMF representing India, Sri Lanka, Bangladesh and Bhutan. Views expressed are strictly personal