Taxes distort economic choices and impede economic growth. Empirical evidence shows that a tax increase of 1 percent lowers real GDP by 1.5 percent after two years. But they are also necessary to fund government spending. So, the issue is how to maximize revenue collection at the lowest possible disruption to the economy.
A good tax policy has the following ingredients: it is (a) broad based (b) proportional (c) simple and predictable (e) easy to monitor to minimize cheating (f) neutral in that it does not unfairly advantage one sector or group over another and (g) easy to implement.
The current tax system in India does not meet any of the requirements of a good tax system. It is not broad based –less than 2% percent of Indians pay income tax. It is not proportional–the tax burden is borne disproportionately by the middle class. It is not simple–the tax code has thousands of complex and often conflicting regulations. It is clearly not easy to monitor since black money is rampant in the country. Tax collection is not equitable among sectors–the agriculture, for example, does not pay any taxes, and hundreds of other distortionary subsidies and exemptions create tax advantages for one group or another. And it is not easy to implement –the average business spends almost 250 hours a year on filing tax returns, and another 400 hours a year on compliance and audits. A recent ( 2016) Word Bank Report ranks the Indian corporate tax code 157th out of 189 countries on how helpful it was towards ‘ease of doing business.’
India needs massive economic growth over the next two decades to raise millions of its citizens from poverty. To accomplish this, the country needs a modern tax code that unshackles capital, increases productivity, and unleashes economic growth; a tax code that is broad-based, simple, fair, and easy to implement; a tax code that encourages people and businesses to produce more, consume more and improve their quality of life.
I propose here a new transformational tax system that starts with abolishing all existing taxes– all 50 or so direct and indirect central and state taxes except import tax. In other words, no more income tax, or corporate tax, or capital gains tax, or service tax, or excise tax. None of these taxes meet the requirements of a ‘good’ tax. A tax on income, for example, is a tax on both consumption and savings ( since income earned is either consumed or saved) and hampers savings and investment. A capital gains tax discourages investment and reduces capital turnover by locking capital in unproductive asset and adversely affecting growth and keeping interest rates artificially high. Corporate tax, the most harmful of all taxes, is effectively a tax on the investors, consumers, and employees of the corporation and has been shown to retard productivity and growth.
Let’s scrap all existing taxes and replace it with a simple tax based on consumption: a value-added tax (VAT), that is automatically imputed into the price of all goods and services. So the tax is automatically paid when people make a purchase, so there is never any tax evasion or black money. It is simple because people never have to worry about keeping records or filing a tax return. And since everyone in the country consumes goods and services, everyone pays some tax which broadens the tax base and increases revenue collection. Our estimates show that if we eliminate all current taxes and replace it with a simple consumption tax, GDP would increase by at least 20% within five years, and government tax collection by 4 percent. Additionally, over 10 million new jobs will be created, and interest rates would drop below 5 percent.
The VAT is a consumption tax that taxes the value added by businesses at each point in the production chain. It applies equally to both manufactured goods and services. Since VAT is a consumption tax, it mirrors a sales tax but is different in that a sales tax is collected only at the final point of purchase, while a VAT is added at every stage of the production process. So when someone buys a pair of shoes, the sales tax is added to the final sales price, but a VAT is added all along the shoe manufacturing process and included in the final price. Because a sales tax is collected at only one point in the production process, customers and sellers can work together to evade it. A VAT is more resistant to tax evasion because businesses collect and remit the tax at every stage of the production process. A tax trail once started cannot be broken without detection thereby eliminating tax evasion.
In the most common form of the VAT, a business pays the VAT tax on its purchase of inputs and collects it on its sales, whether those sales are to another business or the final consumer. Every business simply maintains a record of VAT collected on sales and offsetting VAT paid on its purchases.The company itself pays no taxes since they are passed on to the final consumer. It acts solely as a collection agent for the government, collecting VAT on its sales, and remitting the difference between the VAT collected and the VAT paid on inputs. The burden of the tax moves up the production chain to the final consumer.
The VAT tax is automatically added to everything people buy: the more they consume, the greater the amount they pay in taxes. In that sense, it is proportional because the rich will consume more and hence pay higher amounts in taxes. Critics argue that a VAT would make things more expensive, and add to inflation. This argument is facetious, because, goods are already expensive as a result of all the current state and central taxes. In fact, removing all these taxes will result in prices falling. Economist Dale Jorgensen of Harvard University has shown that getting rid of taxes that penalize saving and investing reduces inflation by increasing business activity and competition. The fact that over 140 countries now use the VAT as a form of collecting taxes is a testimony to its effectiveness.
Another argument against VAT is that it is a regressive tax because the poor consume a larger portion of their income, and, hence would pay a greater share of their income in taxes. This too is a baseless, since in absolute terms the rich will still pay progressively more in taxes because they will consume more and buy more expensive things. The poor do consume a larger portion of their income, but the government could provide a direct rebate of the tax on expenditures to each low-income family. A direct refund would be a more neutral, and less distortive way of providing tax relief to the poor than exempting entire categories like food and clothing from tax. To keep the VAT simple, it should be applied equally to all goods and services, without any exemptions.
Another issue with VAT is in the taxing of services, where, it ‘s hard to determine actual sales since no physical property changes hands. This issue is particularly acute in a country like India where almost 60% of the GDP comes from this sector. For service providers, the value added, i.e., the price of the service minus the cost of inputs, is high, compared to traditional manufacturing businesses, and this creates a strong incentive for service providers and their customers to collude and evade the VAT by transacting in cash. Alternatively, the service provider can under report sales to capture all the benefit of avoiding the tax. In both cases, authorities would have difficulty proving tax evasion without on-site monitoring and inspections. But this concern exists even under the present tax system. Self-employed service providers like doctors, lawyers and accountants can still evade income tax on cash transactions. No tax is 100 percent enforceable, and the VAT is no exception. However, if the penalty for evasion is sufficiently high, the risk from colluding and under-reporting is a strong deterrent. Additionally, scrapping all other taxes would free tax authorities to focus their resources on the enforcement of just the VAT.
Another concern with abolishing all state taxes is the ability of states to raise revenue. The VAT is a central tax, and a good model is required to distribute tax revenue among the states. One approach would be to allocate a percentage of the VAT to the state in which the value was added and the tax collected. Something similar is proposed for the GST tax currently under consideration. Since the tax rate would be identical on goods and services, a VAT is unlikely to favor a manufacturing state over a non-manufacturing state. When state revenues become dependent on the collection of value-added taxes, state governments will be pushed to put in place business-friendly laws and to intensify compliance and collection.
The bottom line is that while no tax is perfect, the VAT tax comes closest to funding government spending at minimal distortion to the economy. It is easier to address the issues with VAT than it is trying to patch the broken system that currently exists. With VAT, for the first time, a significant number of Indians will pay taxes, and because they would have skin in the game, they are likely to be less prone to wasting and stealing government money. They will also be more demanding of how their money is being spent and consequently more responsible in choosing the right representatives. There is clear evidence to show that countries with broad tax bases have lower levels of corruption, less wastage, greater economic prosperity and more mature democracies.
What VAT rate will generate the same tax revenue as all the other taxes it will replace? A quick back-of-the-envelope calculation shows that in 2015 the Gross Value Added (GVA) of all goods and services produced in India was Rs. 115.5 lakh crores. To generate the government’s total expected tax revenue for 2015-2016 of about Rs. 14.5 lakh crores would require a VAT rate of 12.5%. Adjusting for imports and exports gives a GVA of about Rs. 107 lakh crores, which changes the VAT to 13.5%. Accounting for leakages and rebates would suggest that a 15% VAT on all goods and services should produce the same tax revenue as all taxes currently levied in the first year. In subsequent years, tax revenues should be much higher than under the current tax system because of higher than expected economic growth.
Prime Minister Modi recently told members of the Niti Aayog to come up with transformational and not incremental change. If the government wants to unleash economic growth, nothing will be more transformational than abolishing the current growth-destroying tax code and replacing it with a simple value-added tax on all goods and services produced in the country; one single tax across the entire nation, with no exemptions for any product or service. A simpler tax system means easier compliance and less cheating, and very likely the end of black money. A tax policy that encourages savings and does not tax productive capital would unleash massive amounts of capital and lower interest rates. A policy that does not tax corporate profits will unshackle business and entrepreneurs bringing about huge gains in productivity and economic growth, and millions of new jobs in new age companies. The complete removal of income, capital gains, and corporate taxes would also greatly magnify the attractiveness of India as an investment haven for international investors. International capital flows, FII, FDI, would increase, as would repatriation by Indians living abroad.
It’s time to abolish the current tax system and replace it with a modern, growth oriented, simpler and a more reasonable and predictable tax policy. It’s time to transform India.