Budget 2021: Why Finance Minister should not bring in any new tax

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The budget for 2021 is going to be out soon. Finance minister Nirmala Sitharaman faces a huge challenge this year. The COVID pandemic raged through 2020, roiling economies and running many lives. The government’s revenues are down but expenditure commitments are up. What path should the finance minister now take? Should she try and balance the books by levying additional taxes?

EY’s analysis of the historical tax rates in India shows that we have come a long way in achieving the objective of a rational and moderate tax rate regime. For instance, in 1971, the personal tax system had as many as 12 tax brackets, with tax rates ranging from zero to 85%. With a surcharge, the highest tax rate worked out to a staggering 93.5%.

The effective burden of personal taxes was reduced in successive years as the government recognised that moderate rates, a wider base, and higher compliance made for a better tax policy as opposed to high rates. In 1992-93, the tax rates were considerably simplified: only four tax brackets, with the peak rate at 40%. The 1997-98 “Dream Budget” presented by P Chidamabaram 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 with additional surcharges, the highest tax burden is now 42.7%.

The immediate impact of the Dream Budget was a sharp fall in the tax-GDP ratio. But, soon after, moderate rates led to better compliance. The government also took measures to broaden the tax base. So eventually, the tax-GDP ratio got much better.

Budget, personal tax collectors fell by 6%. However, in the next five years (FY1999 to FY2003), the average personal tax-GDP ratio jumped to 1.4% as against 1.2% in the previous five years (FY1993 to FY1997). A similar effect was observed in the corporate tax collections too, where the average CIT-GDP ratio increased from 1.4% in the previous five years (FY1993 to FY1997) to 1.6% in the next five years (FY1999 to FY2003). This sustained increase in the tax-GDP ratio was achieved despite India facing global economic headwinds and a three-year growth slowdown between FY2000 and FY2002.

The data suggest that stability and a gradual moderation of tax rates resulted in a positive behavioural response with better compliance, leading to an increase in the direct taxes-to-GDP ratio in the long run.

India’s peak effective tax rate hovered between 30% and 35.9% till last year. The hike in surcharge rate by the Finance Act, 2020 catapulted the peak rate to the present level.

The Prime Minister has launched the initiative of “Honouring the Honest”. In keeping with this spirit, in times of crisis, the focus may need to be on stability, encouraging compliance, broadening the tax base, and boosting consumption. To this effect, certain measures have already been announced and it is expected that Budget 2021 will be constructed around these themes. In the circumstances, any additional burden on existing taxpayers or any new taxes like wealth tax/estate duty, which were discontinued earlier for reasons of high administrative costs and low revenue yield, may not be in sync.

 

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