India Must Not Chase A Mirage Called Tax-GDP Ratio. The Ratio Is Just Fine

Economists often fret that India does not raise enough taxes, especially direct taxes, and point to the low and static tax-GDP ratio of around 17 to 18 percent, centre and states taken together. Mint newspaper, in an article by Praveen Chakravarty and Vivek Dehejia, has made the same point today (23 February), mirroring Thomas Piketty’s oft-repeated claim that India is more unequal because India collects less taxes from the rich.

Chakravarty and Dehejia, using OECD data, note that “India’s tax-to-GDP ratio increased from 10.4 percent in 1965 to 17.2 percent in 2013…. The corresponding tax-to-GDP ratio for OECD countries (weighted by GDP) increased from 21 percent in 1965 to 33 percent in 2013….” Even compared to countries with lower levels of GDP (South Korea, Turkey, Mexico and Indonesia, among them) “India’s tax-to-GDP is still lower at 17 percent versus an average of 24 percent for these nations.”

So what?

It is not my intention to argue for or against Piketty’s case that inequality in India has risen, but I would certainly like to take potshots at the idea that the tax-GDP ratio needs to be raised (or lowered).

The tax-GDP ratio is an outcome of several trends and processes, and is not something that needs to be targeted. The ratio has to vary from society to society, depending on stages of social, political or economic development, and there is no such thing as an ideal ratio for any country at any time. The ratio is the result of two core factors: the efficiency with which the tax machinery is able to collect taxes currently being levied, and the level of expenditures desired in society. Third, how your country derives the bulk of its income also matters.

When the ratio can vary from less than 2 percent in the oil-rich UAE to more than 50 percent for Denmark, obviously the actual level for any country does not matter.

Coming to India, I would posit that the tax-GDP ratio is relatively fine even when compared to the Turkeys and South Koreas of the world for three major reasons.

First, the level of corruption and the “private” collection of taxes through bribes in every part of the economy, at local, state and central levels, is not being taken into account while calculating the tax-GDP ratio. Of course, we can’t compute how much bribes and corruption add to the level of the tax-GDP ratio, and if we take the level of systemic corruption as important, I would not be surprised if India does not comfortably cross the 20 percent tax-GDP ratio mark.

We pay private taxes for getting birth and death certificates, for driving licences, for subsidised gas connections, for being issued ration cards, for school and college admissions, for “free” hospital services, not to speak of the big episodic collections like the 2G and coal block allocation scams.

If we take the Comptroller and Auditor General’s conservative calculations of revenue forgone in these two scams, these alone would add up to 2-3 percent of GDP, though, admittedly the amounts mentioned (Rs 1.76 lakh crore and Rs 1.86 lakh crore) would have been collected over several years and not just one year. Add the petty daily collections of bribes on octroi, everyday government services, and – most important – land deals, and one can be sure that the actual level of private tax collection will not be less than 3-5 percent of GDP, though this is actually just my guesstimate. As an aside, I must point out that states have high levels of direct taxes on property transactions (stamp duty, registration charges, and other fees) precisely to help facilitate the collection of higher taxes privately.

Second, tax-GDP ratios also depend on the kind of society you live in. High-trust societies can, and will, collect more taxes and people don’t resent paying it because they know the benefits will go to “people like us”. In India, there is no guarantee that any tax collected will go to the kind of people individual taxpayers identify themselves with, whether it is through caste, religion, ethnicity, or language. Denmark can get away with a 50.9 percent tax-GDP ratio because it’s a very small country with a narrow ethnic base. Allow larger migrations from Africa, and as the ethnic composition changes, the ordinary population’s willingness to pay high taxes will diminish.

Third, and this is a larger point, the larger a state, the lower should be its average tax collection per unit of GDP, excluding taxes meant solely to finance social safety net payments to the poor, which would depend on poverty ratios. The amount you must spend on defence or police or bureaucracy should not go up in proportion to your GDP growth. India’s GDP has doubled over the last decade, but payments for defence need not double. Technology should bring down the cost of delivery of services. An Aadhaar-enabled subsidy delivery system should cost less per capita, and this means the same level of absolute taxes should be enough to manage a larger overall subsidy regime.

This truism is actually borne out by Chakravarty and Dehejia’s own numbers, which acknowledge that that there is no correlation between GDP growth and the ratio. They note: “In the 25-year period from 1965 to 1990, India’s tax-to-GDP increased steadily from 10 percent to 16 percent while GDP increased 2.8-fold. In the subsequent 25-year period from 1991 to 2014, India’s tax-to-GDP stayed roughly constant between 16 percent and 17 percent while GDP increased 4.5-fold. It is puzzling to us that just as India broke away from its clichéd Hindu rate of growth post the 1991 economic reforms to grow much more rapidly, its tax-to-GDP ratio stayed constant, belying those who would have predicted an increase.”

Actually there is no puzzle. Economies of scale are kicking in, and also a significant chunk of taxes has been collected privately, as opportunities for big-ticket corruption increased 1991.

The larger issue is this: India must not target the tax-GDP ratio at all. Instead its focus should be on making taxes easier to administer and collect, and the ratio to watch is the level of tax collectible to the amount of taxes actually collected from the population eligible to pay tax, whether direct or indirect. I am sure economists can work these numbers out.

Once this is done, the tax-GDP ratio will automatically correct itself as money moves from private hands to public. The key thing we need to do is improve the state’s administrative efficiency. We need a strong state (which does not mean a big state) to optimise tax collections and spends. The tax-GDP ratio can take care of itself.