Indian Economy, 5th edition (80 page)

Tax

Modern economics
defines
tax as a mode of income redistribution.
1
There might be other ways also to look at it—the usual meaning of tax people think is that a tax is imposed by the government to fulfill its important obligations on the expenditure front.
2
We may take an example to see how taxes redistribute income:

Suppose an economy has a flat rate of income tax, i.e., 30 per cent. Just see the impact of this tax on the income disparity of two people A and B earning Rs. 50,000 and Rs. 80,000, respectively—

We see here that the income disparity of ‘30,000 comes down to Rs. 19,000 after payment of the tax—the income has been re-distributed at the
first
level due to tax.

Now the money the government has got by tax collection, i.e., Rs. 39,000 (Rs.15,000 + Rs. 24,000)

Now the money the government has got by tax collection, i.e., Rs. 39,000 (Rs. 15,000 + Rs. 24,000) will be spent on different sectors—infrastructure, education, health etc—which will provide services to each and everybody alike. Here income is re-distributed at the
secondary
level. Consider a person who pays income tax, but does not take services of government schools for his children’s education, nor goes to the government hospitals for medical services and compare him with a person who has no option other than the government schools and the hospitals—the higher tax payer getting no government services and a lower tax payer getting all the services. Here income looks re-distributed from the consumption side.

Incidence of Tax

The point where tax looks being imposed is known as the incidence of Tax—the event of tax imposition.
3

Impact of Tax

The point where tax makes its effect felt is known as the impact of tax—the after effect of tax imposition.
4

Direct Tax

The tax which has incidence and impact both at the same point is the direct tax—the person who is hit, the same person bleeds.
5
As for example income tax, interest tax, etc.

Indirect Tax

The tax which has incidence and impact at the different points is the indirect tax—the person who is hit does not bleed
6
someone else bleeds. As, for example, excise, sales tax, etc which are imposed on either producers or the traders, but it is the general consumers who bear the burden of tax.

Methods of Taxation

There are three methods of taxation prevalent in economies with their individual merits and demerits—

Progressive Taxation

This method has increasing rates of tax for increasing value or volume on which the tax is being imposed.
7
Indian income tax is a typical example of it. The idea here is less tax on the people who earn less and higher tax on the people who earn more—classifying income earners into different slabs. This method is believed to discourage more earnings by the individual to support low growth and development unintentionally. Being poor is rewarded while richness is punished. Tax payers also start evading tax by showing lower unreal income. But from different angles this tax is pro-poor and taxes people according to their affordability/ sustainability. This is the most popular taxation method in the world and a populist one, too.

Regressive Taxation

This is just opposite to the progressive method having decreasing rates of tax for increasing value or volume on which the tax is being imposed.
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There are not any permanent or specific sectors for such taxes. As a provision of promotion, some sectors might be imposed with regressive taxes. As for example, to promote the growth and development of the small scale industries, India at one time had regressive excise duty on their productions—with increasing slabs of volume they produced, the burden of tax used to go on decreasing.

This method while appreciated for rewarding the higher producers or income-earners, is criticised for being more taxing on the poor and low-producers. This is not a popular mode of taxation and not as per the spirit of the modern democracies.

Proportional Taxation

In such taxation method, there is neither progression nor regression from the rate of taxes point of view. Such taxes have fixed rates for every level of income or production, they are neutral from the poor or rich point view or from the levels of production point of view.
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Usually, this is not used by the economies as an independent method of taxation. Generally, this mode is used as a complementary method with either progressive or regressive taxation. If not converted into proportional taxes, every progressive tax will go on increasing and similarly every regressive tax will decrease to zero, becoming completely a futile tax methods. That is why every tax, be it progressive or regressive in nature, must be converted into proportional taxes after a certain level.

A Good Tax System

What are the characteristics of a good tax system? There has always been a debate among economists and policymakers on the issue of design of the tax system. Taxation in developing economies has been even more debated as the trade-off assessment generates enough controversy. Main debatable issues in the design of a tax system are whether progressive or regressive taxation, direct tax or indirect tax collections should be higher, whether revenue deficit is better, etc. The controversies set apart, there is a broad consensus on five
principles
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of a good tax system, among economists and the policy making experts:

(i) Fairness

Though fairness (i.e., the first criteria of a good tax system) is not always easy to define, economists suggest inclusion of two elements in the tax system to make it fair namely,
horizontal equity
and
vertical equity.
Individuals in identical or similar situations paying identical or similar taxes is known as
horizontal equity.
When ‘better off’ people pay more taxes it is known as
vertical equity
.

(ii) Efficiency

Efficiency of a tax system is its potential to affect or interfere the efficiency of the economy. A good tax system raises revenue with the least cost on the taxpayers and least interference on the allocation of resources in the economy. The tax system affects the economic decisions of individuals and groups by either encouraging or discouraging them to save, spend, invest, etc. Taxes can improve efficiency of economy—taxes on pollution or on smoking give revenue to the government and serves broader social purposes, too. This is known as the
double dividend
of a tax.

(iii) Administrative Simplicity

This is the third criterion which includes factors like computation, filing, collection, etc. of the taxes that all should be as simple as possible. Simplicity checks tax evasion too. Tax reform in India has simplification of tax as its major plank—also recommended by the Chelliah Committee.

(iv) Flexibility

A good tax system has the scope of desirable modifications in it if there is any such need.

(v) Transparency

How much tax taxpayers are actually paying and what are they getting against it in the form of the public services should be ascertainable i.e. the transparency factor.

Methods of Expenditure

Similar to the methods of taxation the modes of government expenditure are also of three types—
p
rogressive, Regressive and Proportional.
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At first instance it seems that as a country achieves better levels of development, sectoral and the item-wise expenditure of the economy must have decreasing trends. But practical experience shows that the level of expenditure needs enhancement everyday and economy always needs more and more revenues to fulfill the rising expenditures. That is why for economies the best form of government expenditure is the progressive expenditure.

The best way of taxation is progressive and the best way of government expenditure is also progressive and they suit each other beautifully. Most of the economies around the world are having progressive taxation with progressive expenditure.

Value Added Tax

The value added tax (VAT) is a method of tax collection as well as name of a state level tax (
at present
) in India. A tax collected at every stage of value addition, i.e., either by production or distribution is known as value added tax.
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The name itself suggests that this tax is collected on the value addition (i.e., production).

Production of goods or services is nothing but stages of value additions where production of goods is done by the industrialists or manufacturers. But these goods require value addition by different service providers/ producers (the agents, the wholesalers and the retailers) before they reach the consumers. From production to the level of sale, there are many points where value is added in all goods. VAT method of tax collection is different from the non-VAT method in the sense that it is imposed and collected at different points of value addition chain, i.e.,
multi-point tax collection
. That is why there is no chance of imposing tax upon tax which takes place in the non-VAT method—
single point tax
collection. This is why VAT does not have a ‘cascading effect’ on the prices of goods it does not increase inflation—and is therefore highly suitable for an economy like India where due to high level of poverty large number of people lack the market level purchasing capacity. It is a pro-poor tax system without being anti-rich because rich people do not suffer either.

Need of VAT in India

Over 150 nations in the world have implemented the VAT system of taxation regarding collecting their indirect taxes. There have been valid reasons why India should move towards the VAT method of tax collection. We may see some of the major reasons:
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(i)
Due to single point tax collection, Indian indirect tax collection system was price-increasing (having
cascading effect
on the price) which was highly detrimental to the poor masses. Implementation of VAT will improve the purchasing capacity and so living standard of the poor people.
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(ii)
India is having a federal political system where side by side the central government states have also been given power to impose taxes and collect them. At the central level, there had been uniformity of taxes for the economy. But there was no ‘uniformity’ at the state level taxes (i.e., state excise, sales tax, entertainment tax, etc.). This was detrimental to the development of a single market for Indian economy as a whole. India bassically had many markets but no Indian market as such. To bring in uniformity at the state-level taxes, VAT was a necessary step in India.

(iii)
With the process of economic reforms, India moved towards market economy. And for this, firstly India needed to have a single market. Without uniformity at the state level taxes (
uniform VAT
) this was not possible.

(iv)
Indian federal design has resulted in economically weaker states and stronger centre. As VAT increases the total tax collection (experience of the world suggests so) it was fit to be implemented at the state level.

(v)
India has been a country of high level tax evasion. By implementing VAT method of indirect tax collection, it becomes almost impossible to go for large scale tax evasion. To prove one’s level of value addition, the purchase invoice/receipt is a must which ultimately makes it cross-check the level of production and sale in the economy.
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(vi)
If some of the state level taxes (which are many) are converted into state VAT the complexity of taxation will also be minimised. And at the end, it is possible to merge some of the centre’s indirect taxes with it, i.e., arrival of the
single VAT
.

k
eeping all such things in mind, India started tax reform (Chelliah
c
ommittee and
k
elkar Committee) and a certain level of sucess has been achieved in this area which can boost our motivation.

In the year 1996, the central government started collecting its excise duty on the VAT method and the tax was given a new name—the CENVAT.

The next proposal was to merge the states excise duty (imposed on intoxicants only) and their sales taxes into one tax—the state VAT or VAT. This could not take place due to states’ lack of political will. Ultimately only sales taxes of the states were changed to be named VAT and was started to be collected on the basis of the VAT method (some states did not join it and some joined later). The experience has been encouraging.

Implementation Experience of VAT

The implementation experience of VAT in India has been very encouraging—the new tax system has been received well by all the stakeholders, the transition being quite smooth.
16
The revenue performance of VAT—implementing states/UTs (25) has been encouraging the tax revenue registered, an increase of 13.8 per cent over the annual growth rate of the last five years.
17
Only 8 states claimed for VAT compensation from the Centre in 2005–06 which came down to only 5 in the fiscal 2006–07.