Tax Policy & Corruption in India


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The ability of a sovereign to levy and collect tax sustainably, on an equitable basis and without overt coercion is a sound measure of the strength of the “social compact” between the State and citizens.

In India, the “social compact” is weak partly due to our colonial past but mostly due to the State evading the obligation thrust on it by a social contract. Citizens do not perceive public funds as belonging collectively to them. State funds are still viewed as belonging to the “ruler”, as they did pre-independence, to either the 250 Indian Princes or the British Raj.

Of course we are poor, which limits the tax potential. Two thirds of Indians (700 million) have a per capita income of less than USD 2 per day. They do not pay any income tax on their earnings but they do pay around 10 to 15% of indirect tax (excise and general sales tax) on the goods and services they consume. But indirect taxes are bundled into the price of goods. They become “invisible” and no individual can wave the tax receipt under the nose of the State and demand to be served.

Of the funds available with State governments (FY 2012 Indian Public Finance Statistics), where interface with the citizen is the most, only 20% is on account of direct taxes (including their share in direct tax collection by the central government). The remaining 80% is all on account of indirect taxes.

Only 34 million Indians (2.8% of the population) pay Income Tax. But it is direct tax, like Income Tax, which creates a clear, direct “contract” between citizens and the State and obliges the latter to do its duty by the former.   Worse still in India 60% of the direct tax collection is from firms, not individuals. Not surprising then that corporates matter more than individual tax payers.

The Income Tax Department recently announced that it had unearthed Rs. 100,000 crore (Rs. 1 trillion) of unaccounted income in FY 2014-no mean achievement on the face of it. But it pales into insignificance against Jawaharlal Nehru University Economist, Arun Kumar’s estimate of “black money” accounting for 50% of India’s GDP, which is around Rs. 90 Lakh crore (Rs.90 Trillion). If Dr. Kumar is right, our Income Tax sleuths got their hands on only 2% of the “black money” circulating in that year.

The impact of tax policy on corruption is ambivalent. Tax people too high, or over regulate the economy and you create an incentive to evade tax and licensing and thereby to operate in the “black economy”- a parallel environment of wealth or income, for which transactions remain unrecorded and on which no tax has been paid. Conversely, not taxing people at all, runs the risk of bankrupting the State and also of losing an opportunity to gauge the “willingness to pay” of citizens for public goods and services provided by the State.

Non-payment of tax is the first manifestation of citizens losing faith in the State. The Mahatma’s Dandi march (1930) was not just a protest against the specific tax imposed on the production of salt, but also highlighted the low levels of satisfaction under British colonial rule.

The “Boston Tea Party” (1773) was a similar event in America, where the flame of nationalism was lit by the spark of protest against unjust colonial taxation of tea by the British, without representation of American interests.

India has neglected the “social compact” building aspect of tax and relied instead on “freebies” like cheap fertilizer, electricity and water; high grain, sugar cane and other cash crop support prices and very low tax on ownership of land, to bribe farmers into a one way social compact, where the government owes them a lot and they owe nothing to the government.

This lack of a “social compact” is most evident between the swelling middle class (500 million strong in rural and urban areas) and the State.  The middle class anger, which Kejriwal’s Aam Admi Party was able to coalesce across the upper middle and the lower middle class, urban voter in the 2014 national elections, most dramatically in Delhi and Punjab, is the anger of inequity. The perceived injury being that they are lumped with the taxes (property tax, income tax, motor spirit tax, entertainment tax, high petrol cost, paying for cross subsidy for free electricity to rural areas) but have little say in government decision making.

Ironically, the consolidation of middle class anger, triggered by Kejriwal against the Congress, helped the BJP and in particular PM Modi, to emerge as a viable leader to further middle class agendas.

Electricity, gas, water supply, road transport utilities; schools, universities, health centers and hospitals are still predominantly owned by the State in India. Most of them suffer for a vicious cycle of low user charges for retail consumers and punitive charges for commercial and industrial users. Despite this price distortion, which creates its own incentives for by-passing formal billing mechanisms or for outright theft, utilities have insufficient revenues to meet costs. Admittedly, some of this is due to inefficiency. But once utilities stop being “profit centers” and become “freebie providers”, they degenerate in operational efficiency over time. Employees lose the motivation to cut costs and maximize efficiency.

Just as the levy of direct tax, even in small amounts, builds “social compact’, paying utilities and State facilities a cost based tariff, is essential for users to feel empowered to demand efficiency from these agencies and for agency employees to view users as valued customers, not petitioners for public services.

Since the mid-1980s this problem of building the social compact has been sought to be addressed internationally by enlarging citizen access to information; creating entry points for citizen participation; making public decision making more transparent and adopting the mechanisms of the direct route for accountability (as opposed to the long route of democratic representation) by bringing government decision making closer to the people (decentralization). These are all useful interventions. (Refer to a paper by Sukhtankar and Vaishnav prepared for the NCAER Policy Forum 2014 for a detailed review of how these tools have been applied in India).

But in the absence of a direct “compact” between the State and the citizen via direct tax and market oriented user charges, citizen empowerment is seriously compromised since citizens do not perceive public funds as money contributed by them.

Rebalancing the presently warped proportion between direct and indirect taxes and rationalizing user charges, is not only necessary for greater tax progressivity; a higher tax to GDP ratio and a higher level obf cost recovery y public utilities, it is critical for “empowering citizens” to ask for more from the State.

If the State fails to make the first move in this direction, the ball will slip into the hands of citizens, as it did in Algeria, Libya and Egypt and nearer home in the Delhi State elections earlier this year.  Large economies, like India, cannot afford the disruption of citizen anger boiling over. The State has better ways of defusing this bomb but it must resolve to apply them.




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