The ability to tax and to punish citizens as per the law is the best metric of sovereignty.
A month has passed. Opinion is unanimous that demonetisation has failed as an instrument to end terror or black money. Brazen terror strikes continue. The shadow industry for converting black into white has perversely got a boost from a new business vertical — converting “old black” into “new black”. Worse still, the economy has taken a severe hit in the process. The good news is that committing mistakes is a sign of executive action. Mistakes fade from public memory if the government learns from them and takes corrective action. So what is the learning?
First, black money is too pervasive to be substantively reduced either via anti-corruption legislation; strong-arm tactics like “raids” or moral persuasion. What can and must be done is to reduce the incentives for avoiding or evading tax. The former is easier than the latter. Tax avoidance is a direct outcome of numerous tax exemptions. These must be rationalised and reduced. Tax exemptions are a non-transparent way of providing a subsidy to either an individual or a business. Because it is not transparent it is difficult to target exemptions narrowly and guard against perverse unintended outcomes. The real estate boom and subsequent bust is one such.
Putting indirect and direct tax together, the incidence of tax at the highest level can be around 43 per cent on an income of just Rs 83,000 ($1,220) a month if the entire amount left over after paying income-tax is spent on purchasing services or goods.
In the United States, the federal income tax rate of 33 per cent is attracted by an income of $75,000 per year. The US is nine times wealthier than India. Factoring in the income differential, the comparable income level in India would be $8,300 per year (Rs 5.6 lakhs per year or Rs 47,000 per month). At this income level, the marginal rate in India is just 20 per cent.
But numerous deductions reduce the effective incidence of tax by a further 10 percentage points. Loan repayment and interest payments for house building, fixed income investments in postal savings, public sector enterprises and infrastructure, capital gains re-invested in specified government bonds, capital gains on equity held for a paltry one year — all qualify for a tax rebate.
These exemptions distort the fixed income market for attracting savings into banking and private business entities. They also do nothing to “pull in” new taxpayers. On the contrary, these exemptions serve as avenues for parking black money through substitution. Instances abound of the entire salary being deposited in such investments with living expenses met from “other” undisclosed sources.
The finance minister proposed, last year, a lower rate of corporate tax of 25 per cent for new assesses if no tax deductions were availed. A similar strategy of reducing the marginal income-tax rate should be followed in Budget 2017 to widen the tax base. Reducing the marginal rate from 30 to 20 per cent can “pull in” new taxpayers. A simultaneous declaration of an intention to reduce the rate further to 15 per cent, depending on the revenue surge, would provide the much-needed assurance of medium-term stability in the tax architecture. The incentives being provided for digital payments and selective targeting of high-profile tax evasion could provide the “push” factor towards better tax compliance. The lesson here is that in a democratic, open economy, incentives work better than directives.
The second lesson is that whilst politics always drives government policy, the consequences of ignoring well-honed governance principles are severe. Institutions matter for sustainable results. Why are 32,290 gazetted tax officers powerless to perform? Are we aware that 36 per cent of available Grade A tax positions are vacant? Is it appropriate that the academic requirements for becoming a tax officer do not mandate having either a masters in commerce or economics or being a chartered accountant? Nor are candidates tested psychologically for their motivations or their ability to put the public interest first. All these red flags show that tax collection has never been a priority. We tend to focus overly instead on the spending departments.
The ability to tax and to punish citizens as per the law is the best metric of sovereignty. To build institutional support for targeting black money we should take a leaf from the British Raj. During the colonial period, the district collectors were the flag-bearers of the Raj. Today, their successors — the Indian Administrative Service — occupy the same high status. But they do everything except collect tax. Those who collect tax — the Central Board of Direct Taxes and the Central Board of Excise and Customs — are condemned to be second-class bureaucrats, perpetually subservient to a revenue secretary from the IAS. The IAS is an elite because it is treated as such by the government. It attracts the best. It trains and gives its members the opportunity to be leaders. If collecting tax is a national priority, we must give the tax officers the privilege of being an elite and leading the tax effort. This will mould them, over time, into being leaders rather than mere camp followers.
A healthy parallel is the possible formation of a tri-services command, in the defence ministry, to establish a direct link between the defence minister and the armed forces. This architecture must be replicated in the department of revenue. Create a “Supreme Tax Council” of secretary-level officers, expert in direct and indirect tax, led by a chairperson in the rank of a minister of state, reporting directly to the finance minister. Consequential changes in the method of recruitment, training, functions, powers and upgrade in the service conditions of the tax services can follow.
Targeting black money is a medium-term task. No government has had the gumption or the political capital to sustain the process. The personal charisma and overwhelming public support that Prime Minister Narendra Modi enjoys places the buck for tax reform squarely at his door.