Economic Environment of Business

Session 8 Managing Public Finances

and Business
Sources of Revenue for the
Government and Tax Reforms

Veena Keshav Pailwar

Professor
IMT Nagpur
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Hall of India
 Chapter 5
Fiscal Policy and Environment

• Objectives of fiscal policy

• Instruments of fiscal policy
• Trends & composition of public revenue & expenditure in India
• Tax and expenditure reform measures initiated in post 1991 era
• Various concepts of deficits and their implications
• Impact fiscal consolidation on revenue and fiscal deficit in India
• Methods of financing government deficit and their implications

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Importance of Government in Economic Activities
GDP = C+I+G+X-M
Where
C = Private Consumption Expenditure
I = Private Investment Expenditure
G = Govt. Consumption & Investment Expenditure
X = Export Govt expenditure can
change the level of
M = Import Transactions with economic activities in
the Other Countries developing countries
by affecting
aggregate demand
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Importance of Govt. Expenditure to GDP

Source: RBI Annual Report 2018 4

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 Fiscal Policy

F is c a l P o lic y

Tax E x p e n d it u r e
or P o lic ie s
R even u e
P o lic ie s

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 Objectives of Fiscal Policy
Fiscal policy
• Has both micro and macro objectives

• Used by both developed and developing countries

• Focus in Developed countries

– Maintaining full employment
– Stabilizing growth

• Focus in Developing countries

– To create an environment for rapid economic growth

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Hall of India
 Union Budget

G o v e rn m e n t B u d g e t
A n n u a l F in a n c ia l S t a t e m e n t

E s t im a t e d R e c e ip t s E s t im a t e d E x p e n d it u r e

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Sources of a Government’s Own Revenue

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Hall of India
 Types of Taxes
Direct Tax Indirect Tax
• It is paid by the people or • Often collected from
organization on whom it is someone other than the
imposed person presumably
responsible for paying the
taxes

• Incidence of the tax may

• Incidence of the tax lies on the
party on whom it is imposed be on the party other than
whom the tax was levied

• Mostly regressive in nature

• Mostly progressive in nature
• Examples: Excise, sales
• Examples: Personal income tax and value added tax
tax, corporate tax, etc.

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 Tax Burden and Tax Incidence
Tax Burden Tax Incidence

• Tax paid in a period as a • Indicates the party who actually

bears the burden of the tax
proportion of total
income in that period
• The party which bears the
incidence of tax is determined by
• Burden can be shifted the market place –elasticity of
by the person who is demand and supply
legally responsible for
paying the tax to • Lower the elasticity of supply or
another party who is not higher the elasticity of demand
higher the tax incidence on the
legally subject to this supplier and vice versa

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 Sources of Non Tax Revenue
Commercial Revenue
– Payments for postage, tolls, electricity charges,
railway services

Administrative Revenue
– Fine & penalties
– License fee
– Gifts and grants
– Etc.

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Sources of Tax Revenue

12
Source: GOI (2016), Economic Survey 2015-16
 Tax System in India
Tax Structure
Three Tier Federal Structure

• Union Government
– Empowered to levy taxes on non-agriculture income &
wealth, corporate profits, custom duties, excise duties,
and service tax

• State Governments
– Levy taxes on agriculture land, income and wealth, sales
tax, excise on alcohol, taxes on motor vehicles, goods &
passengers, duty on entertainment, stamp duties and
registration fees

• Local Bodies
– Empowered to tax properties, impose octroi and charge
for utilities (for example electricity tariff)

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 Tax System in India

Features of Indian Tax Structure

Pre Liberalized Era (Prior to Year 1991)

• High and Multiple Tax Rates, Narrow Base and Complex Tax System
• Regressive Tax System: Large Share of Indirect Taxes
– Direct tax to GDP ratio: 2%; Indirect tax to GDP ratio: 13%
• Allocative Inefficiency
– Services left out from tax base; Manufacturing sector subject to higher and
higher tax rate: affected consumer and producer choice
• Inequity
– Various anomalies in the tax system propagated horizontal inequity and
compromised on vertical equity
• Inadequacy
– Inspite of good deal of buoyancy & elasticity not enough revenue generated:
Growing Fiscal deficit & public debt
• Inefficient
– Large no. of slabs, concessions and exemptions kept the cost of tax collection
very high
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 Tax System in India
High and Multiple Tax Rates: Rising Tax Burden
Personal Income Tax
Year 1973-74
• 11 different slabs
• Rates monotonically rising from 10% to 85%
• Surcharge of 15%
• The highest marginal rate for persons above Rs 2 lakhs was 97.5%

Corporate Tax
• Varied from 45% to 65%
• Although nominal rates were high effective rates were
substantially lower owing to generous provision for depreciation
& investment allowances
• Some companies did not pay any corporate tax for years

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 Revenue Impact of Tax Rate Change
Laffer Curve

Revenue Optimum Point

B

A C

0% 100 %

t1 t* t2 Tax Rate

Before Optimum Point: Increase in tax rate increases revenue

After Optimum Point: Increase in tax rate reduces tax revenue

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 Tax Reforms in India
High and Multiple Tax Rates: Rising Tax Burden
Indirect Tax System: Multiplicity of taxes and rates
Excise Tax Structure: Mix of specific and ad valorem: Rates varying
from 2 percent to 100 percent
Taxes levied at different levels: input, capital goods, final goods:
leading to cascading impact on prices
Large number of quantitative restrictions (QRs) between 50’s to 70’s
on international trade
In 80’s tarrification with replacement of QRs
To raise revenue custom duties were continuously increased
– By 1990-91 the duty ranged from 0 to 300% ad-valorem
The rate structure of sales tax varied across the states without any co-
ordination (Example: 4- 12 % in 1989-90)
Various tax exemptions kept the tax base narrow
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Progressive, Proportional and Regressive
Income Tax System

Tax Paid as % of Income

A

X B

O Y1 Income

Ray XA: Progressive Tax

Ray XB: Proportional Tax
Ray XC: Regressive Tax
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 Progressive, Proportional and Regressive Tax
Structure: An Illustration

Person Income Progressive Proportional Regressive

Tax Tax Tax

Ram ₹100 10% 10% ₹10 (10%)

Shyam ₹1,000 12% 10% ₹10 (1%)

Geeta ₹10,000 13% 10% ₹10 (0.1%)

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 Nature of Taxes and Tax Burden
Type of Tax Nature Burden
Progressive Tax increases as the Burden is less on low
amount to which it is income group and increases
applied as the income increases
Regressive Tax remains the Burden is more on low
same irrespective of income group than high
the amount on which income group
it is applied, i.e. tax
rate declines
Proportional Each tax payer, Proportional income tax:
irrespective of Imposes equal burden on
income, is subject to rich and poor
fixed rate of tax Proportional taxes on
commodities take away a
large proportion of income
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of poor; More burden on20
 Tax Elasticity and Buoyancy
Tax Elasticity
• Measures the responsiveness
of tax revenue to changes in
tax rate
%  Tax Re venue
et 
%  Tax Rate
• et > 1: Elastic system:
Capable of automatically
meeting rising fiscal expenses
• et < 1: Inelastic system:
Incapable of automatically
meeting growth in fiscal
expenses
Tax Buoyancy
• It is a measure of how rapidly
the actual revenue from a tax
rise due to a given change in
the tax base
% Tax Re venue
eb 
%  Tax Base
• eb < 1: GDP growing more
than the tax revenue: tax
structure needs a reform
• eb >1: Discretionary changes
in the tax policy are improving
the responsiveness of the tax
system

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 Tax to GDP ratio: Pre - Reform Period
Indirect Tax to GDP ratio very high
High amount of regressivity in the tax system

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Hall of India
 Tax Reforms in India
Need for Tax Reform
Direct Tax Indirect tax
• Decline in direct tax • Tend to be regressive
revenue • Govt. major consumer
of commodities :
– Tax evasion increase in prices
– Various concessions increases government
– Decline in the tax expenditure
base of income tax • Distorts the production
as well as corporate structure
tax due to • Cascading of taxes
exemptions
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 Tax Avoidance and Tax Evasion
Tax Avoidance
• Occurs when tax payers use
tax laws to reduce the tax
liability applicable on them
• It is legal
• Examples
– Use of various standard
deduction by individuals to
reduce their tax liabilities
– Investment by corporate
entities in R&D to reduce
their tax liability.
Tax Evasion
• Occurs when payers use
illegal means to reduce the tax
liability on them
• Examples
– Corporate units falsely
claiming that the company
has invested Rs worth 1
crore in R&D
– Individuals falsely
declaring that part of their
income is from the
agriculture sector

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 Tax Reforms in India
Committees to Reform the Tax System

• Jha Committee • Indirect Taxation Enquiry

• Choksi Committee • Rationalization of Direct

Tax
• Chelliah Committee • Direct and Indirect Tax Reform

• Raj committee • Agricultural Taxation

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 Tax Reforms in India
Tax Reform Strategy
• Based on the recommendation of Raja Chelliah Committee
Main Recommendations of the Committee
a. Reduction in the rates of important taxes such as personal and
corporate income tax, excise and customs

b. Enlargement of the tax base of various taxes by reducing exemptions

and concessions
c. Transformation of taxes on domestic production into a value added
tax
d. The simplification of laws & procedures to make the administration
and enforcement of the tax system more effective

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 Tax Reforms in India
Tax Reforms: Post 1991 Era

Direct Tax Reforms

Personal Income Tax
• Direct Taxes rationalized
• Marginal tax slabs reduced (Just Three Slabs)
• Drastic reduction in Marginal tax rates:
• Just two tax slabs now (20% and 30%)

Corporate Tax
• Rates reduced from 40 to 30 % for domestic companies

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 Tax Reforms in India
Tax Reforms: Post 1991 Era

Indirect Tax
• Greatly simplified and rationalized
• Progressively switched from a specific to ad valorem levy
• Switched from MODVAT to CENVAT in 2000-01
• Cenvat coverage increased over the years
• Tax net was widened by including many services in the tax
net
• Moved from Cenvat and State Vat to GST on July 1, 2017
• Peak tariff rates have been drastically reduced from 300% to
10% on non-agriculture goods in 2007-08
• Broadening of the tax base: by removing various exemptions
• However, still area based exemptions, SSI excise duty
exemptions and the low rate on selected products restrict the
excise collection.
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 What is VAT?

To Understand the Present Indirect Tax System

we need to understand VAT

and
the present form (GST) in which it exists in India

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 Value Added Tax (VAT)
Feature
• Tax is on the value added
• Value Added = Value of Output – Value of (non-factor)
Input

• Expressed as a percentage tax on the value added on each

stage of production or distribution of a good or service

Methods
– Tax Credit or Invoice Method
– Cost Subtraction Method

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 VAT Vs Excise
VAT Excise
• Tax on value added at each of • Tax on the value of the
production and distribution output produced by the firm

• Value added is estimated through • Distorts the pattern of

cost subtraction method
relative prices and
encourages vertical
• Avoids the cascade feature of integration of firms
excise
• Discriminates against non-
• Neutral in its effect on the
integrated firms
businessman’s decision as to how
he carried on his business
• Discourages ancillarisation
• Greater revenue potential
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 VAT Vs Excise
Let tax rate = 10%

VAT
Value of Output = Rs 100
Value of Int. Inputs = Rs 50
______________________
Value Added = Rs 50
Tax Liability = Rs 5
Market price: 105
Excise
Tax on the value of output(100)
= Rs 10
This is higher than the tax
liability under VAT (Rs 5)
Market Price: 110
Thus, market prices are higher
under Excise

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 Value Added Tax
Let tax rate = 10%
Cost Subtraction Method Tax Credit Method
Value of Output = Rs 100 Subtract tax rebate on
Value of Int. Inputs = Rs 50 taxes paid on inputs
Value Added = Rs 50 from the total tax
Tax Liability = Rs 5 liability
Value of output = Rs 100
Calculated by multiplying value of Tax liability on output Rs 10
output (sales) net of value of Taxes paid on inputs Rs 5
intermediate goods purchased at Total tax liability = Rs 5
each stage of production
(distribution) process with the If no tax paid on inputs
statutory VAT rate. Then tax liability = Rs 10
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 VAT Vs MODVAT
VAT
• Tax on value added at each of
production and distribution
• Value added is estimated
through cost subtraction
method
• Enables the deduction of the
entire value of inputs
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MODVAT
• It is a simplified form of VAT
• Tax liability is estimated through tax credit
method
• Credit is given in respect of the duty paid
inputs: reduces the duty payable on the final
product
• When there is no tax on inputs MODVAT is
similar to excise
• With tax on inputs MODVAT is similar to
VAT
• Ease of computation and compliance has led
to adoption of MODVAT by many countries
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Impact of Excise, VAT and MODVAT on Prices : An Illustration
(Amount in Rs Crores)
Case1 : No Tax on Inputs
Input Tax on Inp VA Output Tax Market Price
Excise (10%) 45 0 50 95 9.5 104.5
VAT (10%) 45 0 50 95 5 100
MODVAT(10%) 45 0 50 95 9.5 104.5

Case2: Tax on Inputs

Input Tax on Inp VA Output Tax Market Price
Excise (10%) 45 5 50 100 10 110
VAT (10%) 45 5 50 100 5 105
MODVAT(10%) 45 5 50 100 5 105

Excise VAT MODVAT Difference Difference Difference

Priceof Commodity Exc-VAT Exc-MVAT MVAT-VAT
Case 1: No Tax on Input 104.5 100.0 104.5 4.5 0.0 4.5
Case 2: Tax on Input 110.0 105.0 105.0 5.0 5.0 0.0
Notations:
VA: Value Added: Value of Output-Value of Inputs including Indirect Taxes on Inputs
Inp: Input
VAT: Value Added Tax: Tax on Value Added
MVAT: MODVAT: Modified Value Added Tax: Tax on Output- Tax on Input

Inferences
1. Market Price of the Commodities is higher in case of Excise.
2. Increase in price in case of Excise is higher when there is tax on inputs
Therefore: There is cascading impact on prices in case of excise
3. When there is no input on tax MODVAT is similar to Excise
4. When there is tax on input MODVAT is similar to VAT

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 Tax Distortions, Reforms and Rationalization
The Post Reform Period: Impact and Assessment (before GST)
• Continuous increase in direct tax to GDP ratio: improvement in
the progressivity of the Indian tax system
– Main driver of growth : corporate income tax
• Indirect tax to GDP ratio decreased
– Decline in excise to GDP ratio: lowering of rates and move
towards VAT – credit extended for taxes on inputs under the
MODVAT/CENVAT
– Decline in custom to GDP ratio: A sharp reduction in the peak
custom duties from 300 % prior to reform to 10% in 2007-08
– Structural changes in the GDP in favour of services & many
services out of the tax net
• A decline in the total tax revenue to GDP ratio: The reduction in
the indirect tax to GDP ratio overweighed the increase in the direct
tax to GDP ratio
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Tax Distortions, Reforms and Rationalization
Impact and Assessment

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 Key Issues/Questions

• Why Goods and Services Tax (GST)?

• Difference between CENVAT and MODVAT

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 Deficiencies in the Indirect Tax System in India
before GST
1. Complex:
• Multiplicity in the types of taxes: Excise, custom duty,
CENVAT, Service Tax, State VAT, CST, etc.
• Multiplicity of levy points in the supply chain: e.g.: excise
at the manufacturing stage, state VAT at the final sale.
• Multiplicity of Rates: Different types of goods subjected to
different tax rates
• Differences in the State VAT: State VAT rates varied across
states
2. Narrow Coverage: CENVAT only upto Manufacturing
Stage; covered only goods; services were kept out of
CENVAT
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3. Cascading impact on Prices
 Important Features of the GST
• Wider Coverage: Covers not only goods but also
services (except alcohol and petroleum products)
• Destination based tax: Tax levied at the destination
• Dual GST: Central GST (CGST) and State GST
(SGST): Centre and state govts entitled to levy it
simultaneously on a common base
• Integrated GST (IGST): levied on inter-state supply:
central govt entitled to collect it
– Import of goods and services subject to IGST (beside
applicable custom duties)
• A non vatable additional tax of 1 % on inter-state
supplies of goods for two years
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 Important Features of the GST
• Tobacco products subject to GST as well as excise
• Small tax payers would have an option of paying flat
rate of duty without availing tax credit.
• Exports zero rated
• Rates of GST decided by the GST council (which
includes Union Finance Minister and Finance Ministers
of different states).
• Input credits of CGST and SGST can not be cross
utilized.

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 Tax Reforms in India
Need for Further Tax Reforms
Further broad basing and simplification of tax system needed

– Warrants withdrawal of tax exemptions and concessions

– Abolition of surcharge from income tax

– Pulling out of area based concessions for infrastructure for backward area development

– Reduction in depreciation allowances from corporate taxes

– Elimination of exemptions from export trading zones, free trade zones & technology parks

Reforms in the tax administration needed

• Warrants improvements in information networking by getting the data from various sources

• Exchange of information between direct and indirect tax administrations

• Exchange of information between Central & State Govts

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