The curious case of moderate taxes and economic growth

Well-designed tax policies have the potential to raise economic growth. Policy makers and economists have often debated about the potential impact of tax rate cuts and their impact on economic growth. The recent corporate tax cuts in September 2019, surely one of the most defining tax policy announcements for India in decades, has led to many views and counter-views with regard to the necessary transmission effect for investments and economic growth at the cost of tax revenues. 

The same debate has now resurfaced in the light of the expectations that personal income tax rates should also be reduced to allow more disposable income in the hands of individuals and revive private consumption.  A quick analysis by the EY Tax & Economic Policy Group reveals that in the Indian experience, while reduction in tax rates may result in a dip in the tax-GDP ratio in the immediate term, over time it has had a positive impact on tax revenues and growth.  Also, contrary to the widespread belief, India is not an outlier in its direct tax collections if one adjusts for its level of development, and non-taxation of agricultural income.

Our analysis of the historical tax rates in India brings out that we have come a long way in achieving the objective of a rational and moderate tax rates regime. For instance, in 1971 the personal tax system had as many as twelve tax brackets, with tax rates ranging from nil to 85%. With surcharge, the highest tax burden worked out to an astounding 93.5%. The effective burden of personal taxes was reduced in successive years as governments recognized that moderate rates, a wider base and better compliance made for a better tax policy as opposed to high rates.  In 1992-93, the tax rates were considerably simplified to have only four tax brackets, with the peak tax rate of 40%. The 1997-98 budget cut the peak personal income tax rate from 40% to 30% and the corporate income tax rates from 40% to 35% for domestic firms. This announcement set the new peak tax rate for personal income tax which continues until today, although the additional surcharges mean that the highest tax burden is 42.7%.

The tax cuts resulted in a sharp dip in the tax-GDP ratio in the immediate term. However, there is evidence that the moderation in tax rates resulting in better compliance, combined with the base broadening measures consistently undertaken by the government, led to a rise in the tax-GDP ratio in the medium to long term. 

In the immediate aftermath of the tax reductions in the Budget of 1997-98, personal tax collections fell by 6%.  However, in the next five years (FY1999-2003), the average personal taxes--GDP ratio jumped to 1.4% as against 1.2% in the previous five years (FY1993-97).  A similar effect was observed in the corporate tax collections too where the average CIT-GDP ratio increased from 1.4% in previous five years (FY1993-97) to 1.6% in the next five years (FY1999-2003). This sustained increase in the tax to GDP ratio was achieved despite India facing global economic headwinds and experiencing a three-year growth slowdown between FY2000 and FY2002. 

The data suggests that the income tax cuts did not lead to a fall in tax revenues as it resulted in a positive behavioral response with better compliance leading to an increase in the direct taxes to GDP ratio in the long run.

Another interesting dimension of India’s tax policy is the common myth that its tax-GDP ratio compares rather unfavorably with other nations. Our analysis of Direct Taxes to GDP ratio vs per capita GDP of 130 countries for the year 2017 shows that India’s ratio of 5.7%, does better than its peer group of countries at the same per capita GDP level. India outperforms or has similar direct tax to GDP collections when compared to countries like China, Russia, Indonesia, Spain, Germany and Sweden, despite having a lower per-capita income (USD 2,000) than these countries.

In fact, if India’s direct tax to GDP ratio is adjusted by removing the agricultural income which is not taxed, then our direct tax collections as a proportion of GDP are even higher at 6.8%. This demonstrates that India is not a poor performer for direct tax collections when adjusted for its per-capita GDP and non-taxation of agriculture income.

Generally, tax rate in developing countries cannot be as high as those of developed countries as these governments are yet to achieve the high levels of capacity necessary to ensure better compliance. Moreover, as high net-worth individuals and capital are increasingly becoming more mobile, high taxes carry the risk of capital flows going over borders. India would do well by consistently focusing on base broadening measures while maintaining moderate tax rates. 

This article was first published in The Economic Times on January 30, 2020.