The Union Budget provides the opportunity for a flat income tax rate and a negative income tax for the poor
In his December 31 speech, prime minister Modi made a pointed reference to the fact that in FY14, as per official ministry of finance data, there were only 2.4 million individuals declaring incomes above Rs 10 lakh. As many have pointed out, no matter what the indicator used (number of big houses, luxury cars, yachts, private planes, etc), this is too small a number for an economy the size, and richness, of India. What this means is that there is a considerable amount of tax evasion—a rough estimate of the order of magnitude is around Rs 6-9 lakh crore on an annual basis. Maybe a strange coincidence, but this number corresponds closely to our estimates of black cash in the Indian economy in FY17, or as of November 8, 2016.
The battle against black income has been an ongoing one. It was included in the manifesto of the BJP government and has been on the agenda since it came to power in May 2014. Besides the government and its supporters, opposition parties in Parliament have demanded that black money held abroad be identified and brought back. Even the Supreme Court came into the picture with the setting up of a Special Investigation Team (SIT) on black money under its oversight/supervision. A number of Acts have been passed by Parliament to tighten the screws and to make it more difficult to hold undeclared assets. And then there was demonetisation on November 8.
As the history of the License Permit Quota Raj shows, that unless the economic incentive favour voluntary tax compliance and less political, bureaucratic and police corruption, any benefits are soon frittered away and negative effects multiply over time. Consequently, institutional reforms for minimising corruption and policy reforms for encouraging voluntary compliance are very important. Something we outline below.
In the US, the IRS has been conducting an annual exercise since 2006, an exercise which attempts to identify the tax losses which arise from income tax evasion. For personal income tax (PIT), the concern of this article, the IRS estimates that of every $100 the US government does collect, about $20 is missed. One of the authors (Surjit) had conducted a detailed exercise on tax compliance in India in 2002; this report was conducted for the ministry of finance under the supervision of Vijay Kelkar (Task Force on Direct and Indirect Taxes). The report found that income tax compliance in India, while varying across income groups, was in the broad range of 10-30%.
Updating the method to the FY14 data (the same as used by PM Modi), we find that there should be approximately 10 million taxpayers earning above Rs 10 lakh, i.e., the compliance rate is only 25%. For all taxpayers, and an estimate comparable to the IRS, we obtain the result that for every Rs 100 obtained in PIT in India, Rs 300 goes missing; on a very conservative basis, Rs 200 goes missing. Whether this is the largest in the world, we do not know—but it has to be close to the top (one area where India is tops!).
This also puts into perspective PM Modi’s anti-black money (or black income) drive. We have consistently argued that the largest low-hanging fruit in the Indian economy is the level of tax compliance. And that one of the goals of demonetisation has to be a change in the tax regime, a change that brings out an increase in tax compliance.
The Union Budget for FY18 will be presented on February 1. We believe that demonetisation has provided the government with the courage, and the vision, of a major reform in direct income taxes. As shown below, we show that one version of this reform is a move to a flat income tax rate of 12 %. Yes, that is the rate the average taxpayer actually paid in FY14!
But what about progressivity in the tax system? Shouldn’t the rich be taxed more? We strongly believe that questions of ethics, and philosophy, and false morality should be kept out of the taxation system. Indeed, those who argue for higher tax rates are often those who have a vested interest in keeping tax rates high in order that their own personal (black) incomes increase—if you think we are hinting at the income tax authority, you are right.
This Budget should be, and we hope will be, about reform of direct taxes. In previous budgets government has proposed reforms of the Corporate Income Tax (CIT). These reforms are in the right direction, but have been carried out too slowly and must be accelerated. The government is on track to introduce GST by August 2017, given that the Constitutional Amendment has been passed—we hope administrative matters will soon be sorted out. Less attention has been focused on reform of the personal income tax and import-export tariffs and duties.
We do believe that the rich, the well-off, should pay more in tax. Hence, this proposal focuses on reform of the personal income tax and the related issue of Direct Cash Transfers (DCT)/Net Income Transfers or Negative Income Tax (NIT). Note that an NIT policy was first outlined by Milton Friedman in the late 1950s.
The accompanying table summarises the important parameters of income tax compliance and revenue collection based on detailed ministry of finance data for FY14 (available at www.incometaxindia.gov.in) and uses these data to make projections for FY17. We want to be as close to revenue neutral as possible, and also provide for NIT.
Some basic facts about I-T in India. In FY17, it is estimated that 62% of the non-cultivator workforce in India earns below Rs 2.5 lakh p.a. That is 205 million earners. Our design of NIT is such that each worker earning below Rs 2.5 lakh will obtain some income transfer. A person with no income will receive Rs 30,000 and one who earns Rs 2.5 lakh, will receive zero income transfer. The bill for NIT, for FY17, is estimated to be Rs 2.92 lakh crore. Where will this money come from ?
From a minimum increase in tax compliance, which presently stands at 25%. The flat tax rate we propose is 12%, the rate actually observed in FY14, and very likely the tax rate estimated by the ministry of finance in making its revenue projections for FY17! (Note that this average rate includes surcharge and cess.)
A flat tax rate of 12 %, even for a tax-shy Indian, should be very appealing. We estimate that at a minimum, the compliance rate will at a minimum increase by 8 percentage points to 33%. This increase in compliance will compensate for the extra revenue needed for the NIT proposal—i.e., Rs 2.9 lakh crore. Incidentally, the tax revenue data for post-demonetisation November and December does suggest that an increase in tax compliance is taking place.
So, will the Union Budget transform India into a moderately tax compliant economy? The Union Budget provides an opportunity for the Modi government to unleash a Big-Bang reform in personal income taxation. The economy provides the scope, and the demonetisation the rationale, for a flat income tax rate and a negative income tax for the poor and the needy. Let not the demonetisation pain be in vain.
Bhalla is contributing editor, The Financial Express, and senior India analyst at Observatory Group, a New York-based macro policy advisory group. Arvind Virmani
is chairman, Policy Foundation. Views are personal. Twitter: @surjitbhalla and @dravirmani