Tax and spend (Please)

Excessive taxation can dull incentives and hinder growth. But too little taxation can do the same. Governments with meager tax revenues can't provide basic public goods. Worse yet, low tax revenues in poor countries often result from defects in tax collection systems (rather than low tax rates) that also promote unproductive enterprise.

India illustrates the importance of a well-designed tax system. In Bangalore, high-tech companies have built world-class campuses replete with manicured lawns and high-speed data communication networks. Outside these campuses, however, lie open sewers, uncollected garbage, and roads in acute disrepair. Whereas technology companies instantaneously transmit terabytes of data to remote continents, local transport proceeds at an almost medieval pace.

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As a result, businesses in Bangalore run their own bus services, contract with private suppliers for drinking water, and install generators to protect themselves from interruptions in electricity supply. The state can't fix the shambles because it is broke. India's government debt exceeds 70% of GDP, so more than half its tax receipts go to paying interest.

But the debt isn't because of excessive spending in the past. India's government expenditures amount to about 15% of GDP, compared to an average of around 40% of GDP in the OECD. Rather, India's financial difficulties stem from a badly designed and administered tax system. Rates and rules for personal and corporate income taxes appear reasonable by international standards. Nonetheless, India's government collects income taxes amounting to only about 3.7% of GDP, about half that in South Korea and the other Asian tigers.

Agriculture in India accounts for about a quarter of GDP, but even wealthy farmers don't pay taxes. Export-oriented companies in the software and other industries enjoy tax holidays on their profits, although their employees do pay taxes on their personal incomes. Despite reasonable rates, tax evasion is widespread.

Cheating occurs because the government hasn't invested in personnel or in the systems to detect tax evaders, who rarely face jail time and can often bribe their way out of trouble when they do get caught. More subtly, the evasion of "direct" taxes on incomes and profits reflects the mess in the system of "indirect" taxes levied on production and consumption.

Excise taxes account for over 60% of India's indirect taxes, which in turn represent the same proportion of its total tax receipts. The basic excise tax has been fixed at 16% of the value of a firm's output. Then there are a variety of concessions, exemptions, and surcharges. For instance a "concessionary duty rate" of 8% is levied on categories like food products, matches, cotton yarn, and computers.

An additional "special excise duty" (SED) of 8% is levied on products that include polyester filament, cars, air conditioners and tires. An "additional excise duty" (AED, not to be confused with the SED) is levied on "goods of special importance."

Exemptions from excise taxes are numerous and complex, including businesses with total annual revenues of less than 10 million rupees and firms located in certain troubled or backward areas. Overall, the exemptions fall under 70 broad categories, subdivided into 259 entries, 52 conditions, and 7 lists, each containing numerous items.

Exemptions invite abuse. For a price, low ranking officials, who have considerable discretion in applying the conditions, can be persuaded to reach favorable interpretations. Goods taxed at high rates (for example, polished granite) are sold as goods taxed at lower rates (for example, as unpolished granite).

Evasion of excise taxes is more contagious than evasion of taxes on profits and incomes. If one firm evades excise taxes, and the tax rate is high compared to pre-tax profit margins in the industry, its competitors also have to cheat, just in order to survive. As evasion increases, governments levy "additional" or "special" duties, inciting further evasion.

Collections of direct taxes also suffer. The bribe paid to the excise tax collector for a favorable classification, the difference between the value of polished and unpolished granite, and the under-reporting of true revenues create "black" funds, which cannot be declared on income-tax returns.

In addition to impairing the state's ability to provide basic public goods, schemes to evade indirect taxes also discourage businesses from adopting more productive technologies, which requires technologies that involve large-scale operation. But, because indirect taxes are more easily avoided by operating many small units instead of one large unit, economies of scale cannot be realized. It's worth noting that in the software industry, where all units are exempt from indirect taxes, Indian companies do operate at efficient scale.

Could India emulate China's example, where the rationalization of indirect taxes in 1994 set the stage for a great boom? Or are coalition governments in a vigorous democracy incapable of such reform?

Last year India's BJP-led government introduced legislation mandating sharp reductions in the budget deficit. It then appointed a task force to formulate the necessary changes in tax and spending policies. This July, the task force proposed raising taxes (rather than cutting spending), through, among other things, removing most indirect tax exemptions. India's new Congress-led government, too, seems to favor these proposals. If Congress and the opposition parties follow through, they will go a long way to sustaining the country's economic growth and in dispelling the idea that democracies cannot do what's needed to encourage development.