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India's Taxing Conundrum

Global data compendium CIA World Factbook puts India's tax collection at 9.3% of GDP, higher than only Nigeria, Syria, Sudan and Burma. So we rank #176 of 180 countries. India's own union budget document indicates tax to GDP of 7.4% which, despite public pronouncements to the contrary, continues to trend lower over the last few years. This can possibly be singled out as the one structural issue that is holding back the Indian economy and, unless addressed on a war footing, can keep us meandering aimlessly to an uncertain future.

Along with our failure to equitably expand tax collections comes our inclination to behave like a welfare state. Subsidies rose to 2.6% of GDP last year from 1.4% five years ago, when our job guarantee program was launched. Now, we are introducing food for all. We need to understand that the welfare state model works best when economic development has reached the entire population, everyone contributes to the tax corpus and the Government redistributes efficiently through public spending. Unfortunately, India doesn't tick any of the above boxes.

And this reflects in our high fiscal deficit, which was 5.4% of GDP last year as per CIA data. The U.S. deficit was higher at 6.9%. Realizing that this is unsustainable, the Americans are targeting a 40% cut over two years. Meanwhile, India's deficit in the first five months this fiscal year has already reached 75% of the yearly objective. At the same stage last year, we were hitting 65% before aggressive spending cuts came in.

Normally, we exercise greater control over plan expenditure which supports the country's growth prospects, while non-plan expenditure (including subsidies) exceeds the budgeted figure. Then deficit financing requires the Government to push its borrowing program, which keeps interest rates high, inflates prices and reduces our global competitiveness, thereby deterring new capital investments and keeping the rupee under pressure.

IMF now estimates India to grow at 3.75% this year based on the expenditure method of GDP calculation. While there is widespread outrage around this new data point, it is interesting to note that the country grew only 2.4% in the first quarter using the same method. So IMF actually expects growth to accelerate over the rest of the year.

And while Q1 growth may have been the weakest in many years, half of it came from the Government's own consumption expenditure, which expanded by over 10%. This tap needs to be turned off if the yearly fiscal deficit target is to be met. Further, second quarter data suggests that both services and manufacturing growth are at 3-year lows. Looks like tightrope walking skills need to be quickly honed.

Coming back to our extraordinarily low tax collections, it may be time for some creative thinking. While our direct tax collection seems to be based largely on individual compliance, indirect taxes are linked to transactions and less reliant on discretion. Scandinavian countries, well-founded welfare states with the highest tax to GDP globally, have successfully focused on indirect taxes. It may be worth an effort trying out this model in India as well.