Can India do away with income tax?

The BJP, as per media reports, may incorporate a proposal to abolish income, sales and excise taxes in its Vision 2025 document, which will be released before the polls. Many in the top leadership have come out supporting the idea in recent weeks. On January 2, Pune-based anti-tax group Arthakranti made a presentation to senior BJP leaders, including Rajnath Singh, LK Advani, Sushma Swaraj, Arun Jaitley, former finance minister Yashwant Sinha and Nitin Gadkari, on simplifying taxation by a flat Banking Transaction Tax (BTT).

 

Not all leaders were impressed initially; most importantly Yashwant Sinha, the former finance minister, said that we would be heading back to the Vedic days. Clearly, there are legal and constitutional issues involved, as sales and excise taxes are in the domain of state governments. And administration of the new regime would require a huge overall of the existing system, most importantly the banking system, notwithstanding the recent Nachiket Mor panel recommendations.

 

It might sound surprising, but there are countries where you do not need to pay income tax (UAE, Qatar, Oman, Kuwait, Cayman Islands, Bahrain, Bermuda, The Bahamas, Saudi Arabia, Brunei Darussalam), as per KPMG's 2012 survey of 114 countries. People in these countries, however, do need to contribute towards social security. Some of these countries are well-known tax havens, while most others have managed to use natural resources to fund government expenses. Can India afford to do away with income taxes?

 

If you are tempted to brush aside the idea of zero income-tax, freshly propounded by Narendra Modi in his speech in Delhi last weekend, because of concerns over revenue and the ability of the government to carry on with governance functions and redistribution a la' a welfare state, think again. The direct taxation of personal expenditures for consumption is one of the oldest yet least tried ideas in the history of taxation. The idea itself has been germane since the 17th century!

 

A number of distinguished economists for over a century have argued that it is the "ideal" form of taxation. The only "perfectly unexceptionable and just principle of income tax", John Stuart Mill contended, is to "exempt all savings". Because savings are excluded from the tax base, its supporters claim that it encourages thrift, which in turn should stimulate investment. Among the most influential work on this theme is by Kaldor who developed the idea of an "expenditure tax" (1955) as a substitute for income tax.

 

The political economy behind taxation:

 

Although largely politically motivated (and you can't fault it purely on this, as all reforms may be attributed accordingly), the fresh Modi proposition has both merits and demerits and deserves a serious thinking, especially given the state of the economy, stubborn inflation and with savings rates having fallen significantly in recent years in India.

 

It is not such a bad idea either:

 

The consumption tax, sometimes referred to as a 'spending tax' or 'expenditure tax', is quite like the income tax, with one key difference being that the tax base is expenditure, not income. Levied directly, tax payers may still file annual returns accompanied with exemptions and deductions, if at all. Irving Fisher, writing in 1942, and earlier advocates of the expenditure tax based their case primarily on the argument that the income tax involved "double taxation" of savings and distorted the choice of individuals in favour of consumption. Thus, not only is the income tax unjust but it encourages consumption and leisure at the expense of thrift and enterprise.

 

Nicholas Kaldor, in his book 'Expenditure Tax' (1955), broadened the case for the expenditure tax by arguing that expenditure was a better measure of ability to pay than income. Kaldor viewed the individual's taxable capacity as his "spending power" which includes all the various forms of economic wealth (stocks of wealth as well as recurrent and irregular flows of money) which must be reduced to a common denominator of so much per annum for tax purposes. Also, allowance should be made for differences in individual needs which make some persons more or less able to pay than others with the same spending power.

 

Kaldor argued that the best way to arrive at a person's spending power vis-a-vis his needs is to look at his day-to-day living expenses. He viewed income as an inferior measure of taxable capacity because it does not encompass spending power in other forms and takes no account of differences among individuals as to the need to save.

 

One major argument put forward against the expenditure tax is that by taking away savings from the tax-base, one tends to favour the rich, as they are in a better position to save larger portions of their incomes. This would render the proposition 'inequitable'. It may also lead to greater concentration of wealth in the hands of few. Kaldor addressed this criticism by arguing that the rates of an expenditure tax can be made steeply progressive in order to tax the rich heavily. One would be still better off, as a large part of the spending by the rich is out of capital, which is generally untouched by the income tax.

 

Another criticism of the consumption base is that it would favour the miser over the spendthrift, even where both had the same spending power or ability to pay. Kaldor's response to this objection goes to the basic rationale of the expenditure tax: People should be taxed on what they take out of the common pool, not on what they put into it. He argued that only by spending, and not by earning and saving, does the individual impose a burden on the rest of the community. In other words, personal consumption drains the resources available to the community for investment and public uses while work and saving add to these resources. This view may not find buyers in many other schools of thought. In addition to value judgments as to the fairest method of direct taxation, important economic considerations are involved in the case for and against the expenditure tax. One generally accepted merit of the tax is that it would be highly effective as an anti-inflationary tool. On the other hand, the tax lacks the automatic stabilizing effect of the income tax in periods of recession. Other economic considerations, such as relative effects on incentives to work, invest and undertake risks are more debatable.

 

Current facts on income tax in India:

 

In contemporary India, income tax is largely a tax on the middle class salary earner. The poor hardly pays any income tax. The rich have dividends and capital gains as large part of their source of income rather than salaries. We could not believe the finance minister when he mentioned in his last Budget speech that only about 42,800 people have declared taxable income of over Rs. 1 crore annually. Further, 400,000 people (with incomes more than Rs. 20 lakh, and constituting 1 per cent of the tax-base) account for 63 per cent of the income taxes collected from individuals in an economy with a tax paying base of 3-4 crore people. Thus, 99 per cent of India's taxpaying people are being coerced into filing their tax-returns, while they pay miniscule amounts as tax on some pretext or other. The guys who pay up are mostly the salaried class, because they can't evade it, as it gets deducted as TDS.

 

Case for replacing income tax by a 'consumption tax' like BTT:

 

The above facts present a strong case around equity for doing away with or even revamping the current income tax regime at the minimum. Why should only a particular class be forced to pay taxes? At least theoretically, this holds ground. In addition, it would render great political mileage to the political parties supporting/proposing such a change. The middle class - both salaried and non-salaried -  who have demonstrated a renewed vigour in political participation in recent elections, would be enchanted by a proposal that reduces their net tax liabilities from existing 10-20 per cent to a mere 2 per cent! The BJP has a potential out-of-the-box match winning idea, especially since it hardly has anything on economic policy for 2014 general election. If some journalists aware of BJP core-thinking group are to be believed, the party is planning to pursue this idea vigorously.

 

But then how would the government make up for the loss in tax-revenue, if it were to scrap income taxes. As per 2013-14 Union Budget, personal income tax has been budgeted at Rs. 2,47,639 crore for the current fiscal year. This, as also in the past years, accounts for about 23 per cent of the total revenue receipts of the govt. The total gross tax revenue of the govt. (including the state's share) stands at about Rs. 12.4 lakh crore (budgeted) in the current fiscal. A two per cent Banking Transaction Tax on current banking transaction can potentially generate about Rs. 15 lakh crore - more than compensating for the loss.

 

The biggest criticism of the BTT is that a large fraction of consumption expenditure in India is still cash (83 per cent by my estimates in 2011, and informally verified by experts in Finance Ministry) and hence we would be leaving a large section of the population out of the tax-net. This is a fair criticism. But, then we surely would be moving up on the 'indifference curve' and getting closer to the Pareto Optimal choice. In plain-speak, the new proposed tax system would be more equitable than the existing one, without compromising on the revenue side.

 

Jay Shankar is an economic adviser at the Department for International Development at the British High Commission. The opinions expressed here are the personal opinions of the author. NDTV is not responsible for the accuracy, completeness, suitability or validity of any information given here. All information is provided on an as-is basis. The information, facts or opinions appearing on the blog do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.