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Tax reform in India: Achievements and challenges

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

TAX REFORM IN INDIA: ACHIEVEMENTS AND

CHALLENGES

M. Govinda Rao*

There have been major changes in tax systems in several countries over
the last two decades for a variety of reasons. The objective of this paper is
to analyse the evolution of the tax system in India since the early 1990s.
The paper describes and assesses the introduction of new forms of direct
and indirect taxes, their revenue and equity implications and the successes
achieved in their implementation. The paper concludes that after eight
years of reform improving the tax system remains a major challenge in
India.

There have been major changes in tax systems of countries with a wide
variety of economic systems and levels of development during the last two decades.
The motivation for these reforms has varied from one country to another and the
thrust of reforms has differed from time to time depending on the development strategy
and philosophy of the times. In many developing countries, the immediate reason for
tax reforms, has been the need to enhance revenues to meet impending fiscal crises.
As Bird (1993) states, “…fiscal crisis has been proven to be the mother of tax reform”.
Such reforms, however, are often ad hoc and are done to meet immediate exigencies
of revenue. In most cases, such reforms are not in the nature of systemic improvements
to enhance the long run productivity of the tax system.
One of the most important reasons for recent tax reforms in many developing
and transitional economies has been to evolve a tax system to meet the requirements
of international competition (Rao 1992). The transition from a predominantly centrally
planned development strategy to market based resource allocation has changed the
perspective of the role of the state in development. The transition from a public
sector based, heavy industry dominated, import substituting industrialization strategy
to one of allocating resources according to market signals has necessitated systemic
changes in the tax system. In an export-led open economy, the tax system should not
only raise the necessary revenues to provide the social and physical infrastructure but
also minimize distortions. Thus, the tax system has to adjust to the requirements of a
market economy to ensure international competitiveness.

* Director, Institute for Social and Economic Change, Bangalore, India.

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

As in other countries, the systemic reforms in the tax system in India in the
1990s were the product of crisis but the reforms were calibrated on the basis of
detailed analysis. The objective of this paper is to analyse the evolution of the India
tax system with special reference to the systemic reforms in the design and
implementation of the structure and operation of the taxes in Indian federal polity. In
section I, the evolution of tax system reforms, alternative paradigms employed in
reform exercises in different countries and the best practice approaches to reform are
described to provide a framework for analysing the Indian tax reform experience.
Section II describes the Indian tax system and the reform initiatives undertaken until
the comprehensive tax reform exercise was taken up in 1991. The salient features of
comprehensive tax reform since 1991 and its impact on revenues are analysed in
section III. The last section brings out the major shortcomings still persisting in
the tax system and lists the challenges faced by the government in developing
a co-ordinated tax system in the Indian federal polity.

I. PARADIGMS OF TAX REFORM

The philosophy of tax reform has undergone significant changes over the
years in keeping with the changing perception of the role of the state. With the
change in the development strategy in favour of market determined resource allocation,
the traditional approach of raising revenues to finance a large public sector without
much regard to economic effects has been given up. The recent approaches to reform
lay emphasis on minimizing distortions in tax policy to keep the economy competitive.
Minimizing distortions implies reducing the marginal rates of both direct and indirect
taxes. This also calls for reducing differentiation in tax rates to reduce unintended
distortions in relative prices. To achieve this, the approach suggests broadening of
the tax bases. Thus, over the years, emphasis has shifted from vertical equity in
which both direct and indirect taxes are subject to high marginal rates with minute
differentiation in rates, to horizontal equity in which, the taxes are broad-based, simple
and transparent, and subject to low and less differentiated rates. Equity in general, is
taken to mean improving the living conditions of the poor. This has to be achieved
mainly through expenditure policy and human resource development rather than
reducing the incomes of the rich as was envisaged in the 1950s and 1960s.
Conventional wisdom on tax reforms provides us with at least three different
model of tax reform. The optimal tax (OT) model (Ahmad and Stern 1991) is
satisfactory in terms of its theoretical soundness, but has been found to be impractical
in its applications. Besides the trade-off between efficiency and equity in tax policy,
the information and administrative costs of designing an optimal tax model have been
found to be prohibitive and, therefore, as a practical guide to tax policy this has not
been useful.

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

The Harberger tax model (HT) like the OT model is well grounded in theory.
It, however, draws much more on practical experience. According to this, while
efficiency (and distribution weights) is clearly desirable in the design of tax policy,
administrative capability is equally, if not more, important. The principal concern,
according to this approach, is not to design a system that will be optimal, but emphasise
the system that will minimize tax-induced distortions and at the same time be
administratively feasible and politically acceptable. In fact, Harberger suggests that
tax reformers should pay less attention to the economic methodology and more to
best practice experiences. The basic HT reform package for developing countries that
are price takers in the international market consists of, inter alia, a uniform tariff and
a broad-based VAT (value-added tax).
The third is the supply-side tax model (SST). This model emphasises the
need to reduce the role of the state. Reduction in the volume of public expenditures
has to be achieved by cutting the tax rates, particularly the direct tax rates to minimize
disincentives on work, saving and investment. The proponents of this model emphasise
the need to broaden the base with minimal exemptions and preferences and to have
low marginal tax rates. Again emphasis is on minimizing distortions in relative prices
and, therefore, the approach emphasises less rate differentiation.
The recent reform approaches combine elements of all three models sketched
above. This incorporates both theory and past reform experiences and takes into
account administrative, political and information constraints in designing and
implementing reforms. The thrust of this approach is to enhance the revenue
productivity of the tax system while minimizing relative price distortions. The best
practice approach has attempted to make the tax systems comprehensive, simple and
transparent. As mentioned earlier, the general pattern of these reforms has been to
broaden the base of taxes, reduce the tax rates and lower the rate differentiation both
in direct and indirect taxes. A broader base requires lower rates to be levied to
generate a given amount of revenues. Lower marginal rates not only reduce
disincentives to work, save and invest, but also help to improve tax compliance.
More importantly, broadening the tax base helps to ensure horizontal equity, is desirable
from the political economy point of view as it reduces the influence of special interest
groups on tax policy, and reduces administrative costs.
In the case of indirect taxation, the reform agenda includes the levy of a
broad-based VAT with minimal exemptions and supplemented by a few luxury excises.
As regards import duties, quantitative restrictions should be replaced by tariffs, export
taxes eliminated, and dispersion in tariffs should be minimized. Personal income tax
too is to be levied on all but a small number of persons with income levels less than
twice the per capita income of the country. Much of the direct taxes should be
collected by withholding, but for the “hard-to-tax” groups, presumptive taxation is to
be applied. Emphasis on horizontal equity also implies emphasis on strengthening
administration and enforcement of the tax and the development of proper information
systems and automation.

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

II. INDIA’s TAX SYSTEM PRIOR TO COMPREHENSIVE

REFORMS 1991

The trends in tax revenues presented in table 1 present three distinct phases.
In the first, right from the 1970s to mid-1980s, there has been a steady increase in
the tax-GDP ratio in keeping with the buoyant economic conditions and acceleration
in the growth rate of the economy. The tax ratio, which was about 11 per cent in
1970-71, increased steadily to 14.6 per cent in 1980-81 (table 1). The ratio continued
to increase steadily during the early 1980s (chart 1). In addition to the economy
attaining a higher growth path, the buoyancy in tax revenues was fuelled by the
progressive substitution of quantitative restrictions with tariffs following initial attempts
at economic liberalization in the 1980s. The economic recession following the severe
drought of 1987 resulted in stagnation in revenues in the second phase until 1992-93.
Following the economic crisis of 1991 and the subsequent reforms in the tax system,
particularly reduction in tariffs, actually caused a decline in the tax ratio. Overall, it
is seen that the tax ratio which reached the peak of about 17 per cent in 1987-88,
declined thereafter to 13.9 per cent in 1993-94 and gradually recovered to 14.6 per
cent in 1997-98. Overall, the level of tax revenues, although reasonable as compared
to the average tax level in developing countries, is clearly inadequate from the
viewpoint of resource requirements of the economy.
In terms of composition of tax revenue, there has been a steady decline in
the share of direct taxes from 21 per cent in 1970-71 to about 14 per cent in 1990-91.
After the introduction of tax reforms in 1992, the revenue from direct taxes has

Table 1. Level and composition of taxes in India

(per cent)

Tax 1970-71 1980-81 1990-91 1995-96 1996-97 1997-98

Direct taxes of which: 21.3 16.4 14.0 20.4 20.5 23.6

Corporation tax 7.8 6.6 6.1 9.4 9.3 9.4
Personal Income tax 10.0 7.6 6.1 8.9 9.1 12.6
Agricultural taxes 2.8 1.0 0.9 0.8 0.6 0.6
Others 0.7 1.2 0.9 1.3 1.5 1.0
Indirect taxes of which: 78.7 83.6 86.0 79.6 79.5 76.4
Customs 11.0 17.2 23.5 20.4 21.4 18.0
Union excise duties 37.0 32.8 27.9 22.9 22.5 20.9
Sales tax 16.6 20.3 20.8 20.4 21.1 21.2
State excise duties 4.1 4.2 5.7 4.9 4.5 5.0
Others 10.0 9.1 8.1 10.9 10.0 11.3
Total tax revenue 100.0 100.0 100.0 100.0 100.0 100.0
Tax-GDP percentage 11.0 14.6 16.4 14.4 14.2 14.6

Source: Public Finance Statistics (various issues); Government of India, New Delhi.

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

Chart 1. Trends in direct and indirect taxes

18
16
14
Per cent of GDP

12
10 Direct
8 Indirect
6 Total
4
2
0
1982-83
1980-81

1981-82

1983-84

1984-85

1985-86

1986-87

1987-88

1988-89

1989-90

1990-91

1991-92

1993-94

1994-95

1995-96

1996-97

1997-98
1992-93
Chart 2. The shares of direct and indirect taxes
100

80 Indirect

Direct
60
Per cent

40

20

0
1982-83

1987-88

1993-94
1980-81

1981-82

1983-84

1984-85

1985-86

1986-87

1988-89

1989-90

1990-91

1991-92

1992-93

1994-95

1995-96

1996-97

1997-98

grown faster than revenue from other taxes as well as GDP and consequently, the
share of direct taxes increased by almost ten percentage points to 24 per cent on
1997-98. An increase was seen in both corporate income and individual income taxes
though, taxes on agricultural land and incomes have continued to decline. In fact,
although the agricultural sector contributes over 30 per cent of GDP, its contribution
to tax revenues is just about half a per cent.
The fastest growth of revenues was in respect of customs during the period
from 1970 until 1992-93, when import duties were significantly reduced. Some
observers attribute this lopsided development of the tax system to the perverse

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

incentives arising from the constitutional arrangement of devolving revenue from

personal income tax and union excise duties to states (see Burgess and Stern 1993
and Joshi and Little 1996). It is also seen that even after reforms were initiated in
1992-93, although the share of revenue from import duties has declined due to reduction
in tariffs, the decline in the share of revenue from union excise duties has been much
faster.
In the Indian federal polity, both central and state governments exercise
revenue powers and the latter raise about 37 per cent of total revenues. The Seventh
Schedule to the Constitution specifies revenue sources of the centre and the states
respectively in the union and state lists 1. The major tax powers of the central
government consist of taxes on non-agricultural income and wealth, corporate profits,
excise duties except those on alcohol and customs duties. The states, on the other
hand, can levy taxes on agricultural land, incomes and wealth, excises on alcohol,
sales taxes, taxes on motor vehicles and goods and passengers, stamp duties and
registration fees. The 72nd and 73rd Constitutional amendments also specify some tax
sources to urban and rural local governments. The two important taxes assigned to
the local bodies are property taxes and taxes on the entry of goods into a local area
for consumption, use or sale. Information on local tax collections consolidated for all
urban and rural local governments is not available. However, available information
shows that local governments have very little revenue raising powers and much of the
expenditures of the local governments are met from devolution of revenues from the
state governments.
Analysis shows that, revenue trends of both the centre and the states follow a
similar pattern (chart 3). However, decline in the ratio of tax revenue to GDP in the
case of the central government has been much faster than that of the states. This is
understandable, as the central government had to reduce tariffs as a part of the structural
adjustment programme. On the other hand, there have been hardly any worthwhile
reforms at the state level and yet, the tax ratio has shown a decline, albeit marginal.

Tax reform attempts until 1990

There have been a number of attempts at improving the tax system since
independence. The principal objective of these attempts has been to enhance revenue
productivity to finance large development plans. Although the various tax reform
committees considered economic efficiency as one of the objectives, the
recommendations do not bear much testimony to this aspect. The recommendations
were in keeping with the philosophy of the times. Further, even when the committees
did recommend certain measures on efficiency considerations, this was not acted upon
if it involved loss of revenues.
1 There is a concurrent list in the schedule as well. However, the tax powers are not assigned in the
concurrent list as the Constitution follows the principle of separation.

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

Chart 3. Trends in tax revenue – centre and states

18
16
14
Per cent of GDP

12
10
8
6
4
Centre Total
2 States
0
1982-83

1991-92
1980-81

1981-82

1983-84

1984-85

1985-86

1986-87

1987-88

1988-89

1989-90

1990-91

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98
The first comprehensive attempt at reforming the tax system was by the Tax
Reform Committee in 1953. This provided the backdrop for the generation of resources
for the Second Five Year Plan (1956-60), and was required to fulfil a variety of
objectives such as raising the level of savings and investment, effecting resource
transfer from the private to the public sector and achieving a desired state of
redistribution.
Since then, there have been a number of attempts, most of them partial, to
remedy various aspects of the tax system. The expenditure tax levied on the
recommendation of the Kaldor Committee in 1957-58 had to be withdrawn after three
years as it did not generate the expected revenues. The attempt to achieve the desired
state of redistribution caused the policy makers to design the income tax system with
confiscatory marginal rates. The consequent moral hazard problems led the Direct
Taxes Enquiry Committee in 1971 to recommend a significant reduction in marginal
tax rates. On the indirect taxes side, a major simplification exercise was attempted by
the Indirect Taxes Enquiry Committee in 1972. At the state and local level, there
were a number of tax reform committees in different states that went into the issue of
rationalization and simplification of the tax system. The motivation for almost all
these committees was to raise more revenues to finance ever-increasing public
consumption and investment requirements.
As mentioned earlier, although the effect of the rationalization has been to
reduce the marginal tax rates, the prevailing philosophy still dictated keeping the rates
very high. It may be noted that in the early 1970s the marginal tax rate including the
surcharge was as high as 93.5 per cent. Combined with the highest marginal wealth
tax rate of 8 per cent tax on wealth, the tax system produced enormous incentives for
evasion and avoidance of the tax. On the recommendation of the Direct Taxes Enquiry

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

Committee, the marginal tax rate was brought down to 77 per cent in 1974-75 and
further to 66 per cent in 1976. Similarly, the highest wealth tax rate was reduced to
2.5 per cent. On the indirect taxes front, the most important reform before 1991 was
the conversion of the union excise duties into a modified value added tax (MODVAT)
in 1986. The MODVAT was introduced in a limited manner on a few commodities
and the coverage was gradually extended over the years. It was an income type VAT
applicable only to a few manufactured goods. Also, there was an attempt to substitute
ad valorem taxes to specific levies though quite a few commodities are subject to
specific tax even today. There were attempts to simplify and rationalize the structures,
but these cannot be considered comprehensive.

III. IMPACT OF TAX REFORMS SINCE 1991

Report of the Tax Reform Committee (TRC)

Tax reform since 1991 was initiated as a part of the structural reform process,
following the economic crisis of 1991. In keeping with the best practice approaches,
the TRC adopted an approach of combining economic principles with conventional
wisdom in recommending comprehensive tax system reforms (see Bird 1989). There
are three parts in the report. In the first interim report, the Committee set out the
guiding principles of tax reform and applied them to important taxes namely, taxes on
income and wealth, tariffs and taxes on domestic consumption. The first part of the
final report was concerned mainly with the much-neglected aspect of reforms in
administration and enforcement of both direct and indirect taxes. The second part of
the report dealt with restructuring the tariff structure. In keeping with the structural
adjustment of the economy, the basic principles taken in the recommendations were to
broaden the base, lower marginal tax rates, reduce rate differentiation, and undertake
measures to make the administration and enforcement of the tax system more effective.
The reforms were to be calibrated to bring about revenue neutrality in the short term
and to enhance revenue productivity of the tax system in the medium and long term.
The overall thrust of the TRC was to (i) decrease the share of trade taxes in total tax
revenue; (ii) increase the share of domestic consumption taxes by transforming the
domestic excises into VAT and (iii) increase the relative contribution of direct taxes.
The important proposals put forward by the TRC included reduction in the
rates of all major taxes, viz. customs, individual and corporate income taxes and
excises to reasonable levels, maintain progressivity but not such as to induce evasion.
The TRC recommended a number of measures to broaden the base of all taxes by
minimizing exemptions and concessions, drastic simplification of laws and procedures,
building a proper information system and computerization of tax returns, and a thorough
revamping and modernization of the administrative and enforcement machinery. It
also recommended that the taxes on domestic production should be fully converted

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

into a value added tax, and this should be extended to the wholesale level in agreement
with the states, with additional revenues beyond the post-manufacturing stage passed
on to the state governments.
In the case of customs, the TRC recommendations were the weakest.
The TRC recommended tariff rates of 5, 10, 15, 20, 25, 30 and 50 to be achieved by
1997-98. The tariff rate was to vary directly with the stage of processing of
commodities, and among final consumer goods, with the income elasticity of demand
(higher rates on luxuries). Excessive rate differentiation (seven rates) and according
varying degrees of protection depending on the stage of processing has been severely
criticized by Joshi and Little (1996, p. 74) when they state, “….this is a totally
unprincipled principle, for it has no foundation in economic principles”. In addition
to continued complexity, the proposed tariff structure creates very high differences in
effective rates and provides a higher degree of protection to inessential commodities.
The TRC recommendation also falls much short of developing a co-ordinated
domestic trade tax system in the country. This, in a sense, is understandable, as it had
no mandate to go into the state level taxes. However, the Committee was aware of
the serious problems of avoidance and evasion in respect of sales taxes levied by the
states predominantly at the manufacturing stage. Therefore, it did recommend the
extension of the central VAT to the wholesale stage with the revenues from the extended
levy assigned to the states.

Implementation of reforms since 1991

The government accepted the recommendations of the TRC and has

implemented them in phases. Although it did not entirely follow the recommendations
and is yet to implement many of the measures to strengthen the administration and
enforcement machinery, most of the recommendations have been implemented. It
must also be noted that the pace and content of reforms have not been exactly true to
TRC recommendations.
As regards the personal income taxes, the most drastic and visible changes
have been seen in the reduction in personal and corporate income tax rates. In the
case of personal income taxes, besides exemption, the number of tax rates have been
reduced to three and the tax rates were drastically reduced to 10, 20 and 30 per cent.
At the same time, the exemption limit was raised in stages to Rs 50,000. Combined
with the standard deduction, a salaried taxpayer up to an income of Rs 75,000 need
not pay any tax. In addition, saving incentives were given by exempting investment
in small savings and provident funds up to a specified limit. Attempts have also been
made to bring in the self-employed income earners into the tax net. Every individual
living in large cities covered under any of the specified conditions (ownership of
house, cars, membership of a club, ownership of credit card, foreign travel) is
necessarily required to file a tax return. Empirical evidence shows that this drastic

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

reduction in the marginal tax rates has improved the compliance index significantly 2.
Thus, revenues from personal and corporate income taxes have shown appreciable
increases after the reforms were initiated in spite of the fact that the rates of tax have
been reduced significantly. Voluntary disclosure scheme to allow a one time amnesty
to tax defaulters by paying the necessary tax was introduced in 1997-98.
In the case of corporate income taxes, the rates were progressively reduced
on both domestic and foreign companies to 35 per cent and 48 per cent respectively.
The dividend tax at the individual income tax level has been abolished. However,
very little has been done in terms of broadening the base of corporation tax. In fact,
besides depreciation allowances and exemptions for exporters, generous tax holidays
and preferences are given for investment in various activities (housing, medical
equipment, tourism, infrastructure, oil refining, free trade zones, software development,
telecommunication, sports etc.). Consequently, the tax base has not grown in proportion
to the growth of corporate profits. As many corporate entities took generous advantage
of all these tax preferences, there were a number of “zero-tax” companies. To ensure
minimum tax payments by them, a Minimum Alternative Tax (MAT) was introduced
in 1997-98.
In the case of tariffs, there has been a drastic reduction in both the average
and peak tariff rates. In 1990-91, the unweighted average nominal tariff was 125 per
cent and peak rate was 355 per cent. These were progressively reduced over the
years. The peak rate of import duty in 1997-98 was 40 per cent and the average rate
of tariff is just about 25 per cent. It is proposed to reduce the tariffs further to the
levels prevailing in the South-East Asian countries in the next five years. In terms of
rate differentiation, the number of tax rates continues to remain high. While in the
initial years, there was an attempt to reduce the rate differentiation, in more recent
years, the variations have, in fact, increased. Again, the pattern of tariffs with the
rates varying with the stage of processing has resulted in very high incentives given
to the assembly of consumer durables and luxury items of consumption.
There has been a considerable simplification and rationalization of union
excise duties as well. Besides reduction in the number of rates, the tax has been
progressively converted from a specific into ad valorem levy in respect of the majority
of commodities. The facility of providing credit on input taxes under the MODVAT
too has been progressively extended to a larger number of commodities. As of now
almost 80 per cent of the goods covered under excise duties are provided with the

2 Compliance index is defined by Dasgupta and Mookherjee (1998, pp. 73-74) as the fraction of taxes that
are liable that is actually paid. To get the taxes liable, the authors assume that the tax base is a constant
proportion of non-agricultural GDP. This is weighted with the average effective tax rate to take into account
exemptions and deductions. The ratio of actual tax revenue collections to this estimated base gives the tax
compliance index.

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MODVAT facility. The base of the tax was broadened by removing the exemptions
and levying excise duty at the lowest rate (8 per cent). There has also been a
simplification of the tax on the small-scale sector. As the government realized that
there was considerable misuse, availability of MODVAT credit was reduced to 95 per
cent instead of 100 per cent.
Another important change that has been brought about since 1991 is the
introduction of a selective tax on services. The constitution does not assign this tax
base specifically either to the centre or the states. However, the central government
by invoking residuary powers has introduced a tax on services since 1994-95.
Beginning with three services (telephones, non-life insurance and stock brokerage),
the base of the tax has been broadened to cover a large number of services such as
transporters, car rentals, air travel agents, architects, interior designers, management
consultants, chartered accountants, cost accountants, company secretaries, credit rating
agencies, market research agencies, underwriters, private security/detectives, real estate
agencies and mechanized slaughter houses.
There have been significant attempts to improve the administration and
enforcement of the tax as well, though progress in actual implementation has not been
commensurate. Besides amnesties given from time to time, efforts have been made to
reduce arrears by introducing simplified assessment procedures. A large number of
pending cases in courts have been decided through out of court settlements. There
have also been attempts to establish special tax courts to deal exclusively with tax
disputes. With the assistance of the Canadian International Development Agency
(CIDA), the government has started an ambitious programme of computerising tax
returns and building a management information system.

State tax systems

While a good deal of progress has been made in the tax system reform of
the central government, progress in the case of state tax systems has not been
commensurate. The sales taxes, which account for over 60 per cent of states’ revenues,
have, over the years, become stagnant. The states prefer to levy the tax at the first
point of sale, and this makes the tax base narrow. With as many as 16-20 rate
categories introduced to fulfil a variety of objectives, the tax has become complicated.
This has given rise to a large number of classification disputes as well. Taxation of
inputs and capital goods, in addition, has contributed to cascading. In an imperfect
market characterized by mark up pricing, the taxes on inputs and capital goods results
in the phenomenon tax-on-tax, and mark up on the tax with consumers paying much
more than the revenues collected by the government. In addition, there is a tax on
inter-state sales, which not only causes severe distortions but also results in inter-state
tax exportation in favour of richer states. All these have combined to make the sales
tax system complicated, opaque and distorting. Above all, with independent and

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

overlapping commodity tax systems at the central and state levels 3, co-ordinated and
harmonized development of domestic trade taxes has become difficult.
The Government of India appointed a study group to recommend measures to
harmonise and rationalize the domestic trade tax system in the country (India 1994).
The study group made a thorough analysis of the distortions of the prevailing system
of taxation and has recommended the gradual moving over to destination based,
consumption type value added taxes at the state level. At the central level, the study
group recommended complete switching over to the manufacturing stage VAT. At the
state level, the existing sales taxes were to be transformed into retail stage destination
type VAT.
In order to persuade the states to rationalise their tax systems on the lines
recommended by the study group the Government of India appointed a state Finance
Ministers’ Committee. The Committee has made recommendations to switch over to
the VAT in a given time frame through stages. Unfortunately, in spite of the consensus
on the need for reforms in the sales tax systems at the state level, there has been very
little action in terms of actual rationalization.

Revenue implications of reforms

The economic crisis of 1991 resulted in a significant decline in revenues.

Although the tax reforms were intended to be a revenue neutral exercise, the natural
consequence of a significant decline in tax rates was to reduce revenues. As there
was no commensurate increase in the tax base, the revenue naturally showed a declining
trend. Thus, the tax-GDP ratio, which was over 16 per cent in 1990-91, declined
sharply to less than 14 per cent in 1993-94. Although thereafter there has been some
improvement, it still remains less than 15 per cent and this remains a matter for
concern (India 1994). Thus, the reforms in the Indian context have in fact, caused
an immediate loss of revenues, though in the next few years, they are likely to reach
pre-reform levels.
Interestingly, in spite of significant reductions in the rates of both individual
and corporate income taxes, the revenues have shown a significant increase. The
share of revenue from direct taxes showed a significant increase as a proportion of
GDP as well as total tax revenue. The contribution of revenue from direct taxes,
which was less than 14 per cent in 1990-91, increased sharply to 24 per cent in
1997-98. However, it is not clear to what extent the increase in revenue productivity
is due to increase in public sector wages following the implementation of pay
commission recommendations, how much of this is attributable to better compliance
arising from lower marginal tax rates and how much due to administrative measures.

3 There is also a commodity tax at the local level called “octroi”. This is a tax on the entry of goods into
a local area for consumption, use or sale. This tax is levied by urban local bodies and is levied in many
states.

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The decline in the tax-GDP ratio since the reforms were initiated has to be
attributed to lower yield of indirect taxes. Naturally, some reduction in customs
revenue was only to be expected as the prevailing tariffs were extremely high and had
to be drastically reduced. For the same reason, the reforms in excise duties were to
be calibrated to compensate revenue loss from import duties. This, however, did not
happen and in fact, the revenue from union excise duties showed a drastic decline.
Analysis shows that the revenue from import duties as a ratio of GDP declined by
1.3 percentage points from 3.9 per cent in 1990-91 to 2.6 per cent in 1997-98.
However, decline in the revenue from excise duties was faster, by 1.5 percentage
points from 4.6 per cent to 3.1 per cent during the same period. Consequently, the
share of excise duties in total revenue declined by about 7 percentage points (from
28 to 21 per cent) as compared to a 6 percentage point decline in the share of customs
(from 24 to 18 per cent). Significant improvements in the tax ratio, therefore, have to
come from improvement in the revenue productivity of domestic indirect taxes.
The continued heavy reliance on import duties as a source of revenue rather
than as an instrument of protection is an issue that merits some discussion. It has
been pointed out that the central government does not have the incentive to raise
revenues from the taxes that are shared with the states. According to the existing
intergovernmental fiscal arrangement, the central government should share 87.5 per
cent of the net collections from personal income tax and 47.5 per cent of gross revenues
from union excise duties with the states. This is alleged to have created a moral
hazard problem and it is stated that the central government concentrates on those
taxes which are not shared. Consequently, while the share of revenues from the taxes
that are shared with the states have declined, the revenues from the sources that are
not shared have shown a steady increase (chart 4). Therefore, Joshi and Little (1996,
pp. 93-94) state, “…there is no doubt that this cockeyed growth of the tax system has
harmed the development of the whole economy.”

Chart 4. Composition of shared and non-shared tax revenues

of central government
80
Per cent of total central tax revenues

70
60
50
40
30
20 Shared taxes
10 Non-shared taxes
0

1950-51 1955-56 1960-61 1965-66 1970-71 1975-76 1980-81 1985-86 1990-91 1995-96

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Asia-Pacific Development Journal Vol. 7, No. 2, December 2000

IV. SHORTCOMINGS AND CHALLENGES

After eight years of tax reform, as already mentioned, a number of disquieting

features in the tax system still remain. Improving the productivity of the tax system
continues to be a major challenge in India. The tax ratio is yet to reach the
pre-reform levels. Although the coverage under income tax has shown significant
improvement, much remains to be done to reach the hard-to-tax groups. The ratio of
domestic trade taxes in particular has continued to decline and this has posed a major
constraint in reducing tariffs which is necessary to achieve allocative efficiency.
Designing of tariffs itself needs to be re-examined to ensure lower tariffs a well as a
low level of dispersion to ensure that effective rates of protection are as intended.
Reforms in excise duties have not reached the stage of achieving a simple and
transparent manufacturing stage VAT. Much remains to be done to simplify and
rationalise the state and local consumption taxes. Concerted efforts are necessary to
create a proper management information system and automating tax returns. Above
all, tax reforms should become systemic, a continuous process to keep the economy
competitive instead of being sporadic and crisis-driven.
In the case of direct taxes, as already mentioned, the revenue ratio has shown
an upward trend. Marked decline in tax rates seems to have improved tax compliance,
though much of the increase seems to have come about due to increases in public
sector wages. Yet, the revenues realized are nowhere near the potential and much
remains to be done to improve the horizontal equity of the tax system by extending
the tax net to hard-to-tax groups. The criteria stipulated for filing tax returns has
increased the number of tax returns from less than half a per cent of population to
more than 2 per cent. But this has not brought about a corresponding increase in
revenues. Inability to bring in the hard-to-tax groups into the net has continued to
exert pressure to increase the standard exemption limit deductions. There is also
scope for rationalizing savings incentives. Perquisites continue to receive favourable
tax treatment and the coverage of tax deduction at source needs to be expanded before
long.
In the case of corporate income taxes, too, it is necessary to broaden the tax
base by minimizing tax concessions and preferences. Rather than minimizing them,
the recent coalition governments have gone about proliferating tax incentives to
complicate the tax system and to create a wide wedge between the nominal and
effective corporate tax rates. As the companies started using the provisions, for revenue
reasons, the government started levying the minimum alternative tax (MAT). Thus
one imperfection was sought to be remedied through another. This has complicated
the tax system further.
As already mentioned, complete rethinking is necessary in designing tariffs.
The TRC recommendation of having seven tax rate categories, the rates varying
according to the stage of production, would create large dispersal in the effective rate

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of protection. Levying lower rates on necessities and higher rates on consumer durable
and luxury items of consumption enormously increases protection to these products.
It is essential that the highest tariff rate should be brought down to 15-20 per cent and
there should be no more than three rate categories. Unless this is done, it would not
be possible for Indian manufacturing to achieve international competitiveness in the
medium term.
The most important challenge in restructuring the tax system in the country
is to evolve a co-ordinated consumption tax system. Although tax assignment between
different levels of government follows the principle of separation, as these separate
taxes levied by the centre (excise duties), states (sales taxes, state excise duties, taxes
on motor vehicles, goods and passengers), and local governments (octroi) fall on the
same tax base, we end up in a chaotic situation with tax on tax and mark up on the
tax. Besides cascading and relative price distortions, this results in a totally
non-transparent tax system. Development of dual VAT – a manufacturing stage VAT
by the centre and a consumption type destination based retailed stage VAT by the
states is a solution, which needs to be progressively applied. However, neither the
centre nor the states have made appreciable progress in this regard. To achieve this,
in the case of the centre, the excise duties should be levied entirely as ad valorem
levies. The rates should be rationalised into a maximum of two and tax credit should
be provided on a systematic basis. For this, developing a proper information system
is imperative. At the state level, transforming the state taxes into VAT has to be
calibrated even more carefully. Rate rationalization, systematic provision of tax credit
on inputs and those paid on previous stages, removal of competing tax incentives and
concessions, zero rating the tax on inter-state sales – all these have to be done in
phases.
A major difficulty in evolving a destination based retail stage VAT at the
state level arises from the fact that the states do not have the power to levy tax on
services. As mentioned earlier, the states can levy sales taxation of only goods.
Taxation of services is not assigned to either the centre or the state, but the former
levies taxes on selected services based on power to levy taxes on residual items.
Proper levy of goods and services tax would, therefore, require an amendment of the
Constitution. The central government can use this as a leverage to persuade the states
to reduce and eventually eliminate the taxation on inter-state sales so that a levy of
destination based VAT becomes a reality.

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REFERENCES

Ahmad, Ehtisham and Nicholas Stern, 1991. The Theory and Practice of Tax Reform in Developing
Countries (Cambridge, University Press).
Bagchi, A, 1994. “India’s tax reform: a progress report”, Economic and Political Weekly, vol. XXIX,
22 October, pp. 2809-2815.
Bird, R.M., 1989. “Administrative dimension of tax reform in developing countries”, in Malcolm Gillis,
ed., Tax Reform in Developing Countries (London, Duke University Press).
_______ , 1993. “Tax reform in India”, Economic and Political Weekly, vol. XXVIII, 11 December,
pp. 2721-2726.
Burgess, Robin and Nicholas Stern, 1993. “Tax reform in India”, Working Paper No. 45, STICERD,
London School of Economics.
Dasgupta, Arindam and Dilip Mookherjee, 1998. Incentives and Institutional Reform in Tax Enforcement
(Oxford University Press).
Harberger, Arnold, 1990. “Principles of taxation applied to developing countries: what have we learned”
in Michael Boskin and Charles McLure, Jr., eds., World Tax Reform: Case Studies of Developed
and Developing Countries (San Francisco, ICS Press) pp. 25-46.
India, 1994. Reform of Domestic Trade Taxes in India: Issues and Options, Report of the Study Team
(Chairman: Dr Amaresh Bagchi)
Joshi, Vijay and I.M.D. Little, 1996. India’s Economic Reforms 1991-2001 (New Delhi, Oxford University
Press.

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