Some “fiscal” problems in India’s fiscal policy
Let’s focus on some popular misconceptions or lesser known facts about fiscal policy in India.
First of all, many people belonging to the so-called “middle class” complain that while they pay taxes, the poor do not pay, but still receive all government subsidies. It’s not true. Poor people pay all kinds of indirect taxes like GST, excise tax, sales tax when they buy a brand name soap or a tube of toothpaste or medicine or recharge their cell phones every month or pay bus tickets that are inflated by all sorts of excise taxes imposed by central and state governments on petroleum products.
Second, not all wealthy people pay income tax. Wealthy farmers in India do not have to pay taxes on so-called “farm income”. On the other hand, employees for whom taxes are deducted at source have no means of escaping the payment of income tax. However, even here, an individual under the current income tax rates and exemptions can earn around ₹7.5-8 lakh per year without paying income tax using various tax deductions. This means that a family consisting of a husband and wife can earn up to ₹15 lakh in income per year (which without any stretch of the imagination can be considered a not well off family in India) without paying income tax.
A regressive tax regime
Third, tax revenues from indirect taxes such as GST, customs duties, sales taxes and excise taxes are becoming increasingly important relative to tax revenues generated from direct taxes such as personal income and corporate income tax. Since indirect tax rates are the same for everyone, regardless of income level, the Indian tax system becomes less progressive over time.
Fourth, even if the tax exemption limit and the tax rates of different tax brackets are not changed (as in the last budget), taxpayers end up being harmed in an inflationary situation. Suppose prices increase by 10% and everyone’s money income also increases by 10%, real income remains the same. Yet people would move to higher tax brackets and have to pay a higher percentage of unchanged real income in taxes.
Fifthly, some people wonder: why does the government prefer to spend more money on infrastructure development instead of giving tax advantages or putting more money directly into the hands of the people so that they spend it? There are several possible reasons.
First, economic theory tells us that additional government spending has a greater effect on aggregate demand than an equal reduction in tax revenue. So, with the same level of budget deficit, it makes sense to rely on additional government spending rather than demand-created tax cuts.
Second, spending on infrastructure projects (like building roads, ports, bridges, airports, power plants) creates demand through the creation of productive jobs instead of doles. It is true that more money transferred to the poor by taxing the rich would increase net aggregate demand because the poor have a higher propensity to consume.
Moreover, the effect would be more immediate since it takes time for new infrastructure projects to start. But that would not create new national assets. On the other hand, better physical infrastructure should attract more private investment which, in turn, would increase the productive capacity of the nation in the future. The long-term trend growth rate of an economy depends on growth in productive capacity rather than growth in aggregate demand.
Sixth, many media commentators are expressing dismay at the huge shortfall in achieving the divestment goal. Here we need to understand the distinction between strategic selling (which changes management and control, as in the case of Air India) and simple equity dilution (by selling some PSU shares). If strategic selling is not possible (because no strategic investor comes forward), it may be better to wait rather than hastily sell some PSU shares at existing prices to present a better budget deficit figure. The focus should be on improving efficiency through divestment rather than fundraising for government.
Finally, some tax benefits do not provide benefits to the most targeted beneficiaries. For example, all purchasers of health insurance must pay GST at a high flat rate of 18%. Under 80D, they can deduct the premium payment including GST (up to a certain maximum limit like ₹50,000 for seniors) from taxable income and thus gain tax benefit.
But, consider the case of a low-income senior whose annual taxable income falls below ₹5 lakh. Under the current tax system, he does not have to pay income tax but will still have to pay the 18% GST on the health insurance premium without benefiting from any tax deduction. But a wealthy person with a marginal income tax rate of 30 percent plus a surtax would enjoy a significant tax advantage.
The author is a former Professor of Economics, IIM, Calcutta and Cornell University, USA
February 18, 2022