India shows neighbours the way out of tax trap

Narendra Modi’s occasionally fumbled attempts at economic reform have achieved one major success: for the first time in its post-independence history, India appears to be building a stable tax base to fund its long-neglected public services.

Since India’s prime minister announced the abrupt cancellation of 86 per cent of the country’s cash in late-2016, tax officials have reported millions of new people have registered to pay tax for the first time.

According to India’s latest economic survey, 10.1m people filed income tax returns for the first time between November 2016 and November 2017, compared with an average of 6.2m in the preceding six years.

Since then, small businesses have flocked to sign up for the country’s new national goods and services tax, which has boosted the country’s indirect tax base by 50 per cent.

The numbers are so stark that some say it will go down as Mr Modi’s greatest economic legacy, while others are offering India as a model for other developing countries looking to tackle widespread tax evasion.

Sudhir Kapadia, a tax partner at EY in India, said: “Both demonetisation and the GST have led to a jump in the number of people filing income tax returns, though it has taken a while for the results to filter through. Along with the new insolvency code, this will go down as the most effective reform Modi has implemented.”

India has long suffered from a narrow tax base, with many of the countries richest people finding ingenious ways to avoid declaring their income to the government. 

Total tax revenues in 2016 amounted to about 17 per cent of the country’s gross domestic product, according to the country’s annual economic survey. That is only 4 percentage points above where it was in the mid-1980s. Economic growth has averaged 6.5 per cent since then.

India’s tax-GDP ratio is the lowest of all the Brics countries, with China at 20 per cent, Russia at 22 per cent, South Africa at 26 per cent and Brazil at 32 per cent. The average for OECD countries is 34 per cent, according to data from the IMF and the OECD.

As a result, India suffers from underfunded public services, leading to lower literacy rates and lower life expectancy than most of its fellow major middle-income countries. Other South Asian countries are in an even worse position: Pakistan’s tax-GDP ratio for 2016-17 was 12.5 per cent, while that in Bangladesh is about 11 per cent.

But there are signs that might be about to change for India.

When Mr Modi announced his “demonetisation” experiment, he listed tackling tax evasion as one reason, with many Indians hiding their wealth in banknotes at home. 

The immediate evidence was that the policy had not achieved its goal of filtering out untaxed cash — 99 per cent of outstanding notes were successfully deposited back into the banking system. But since then, tax officials have reported a jump in the number of tax returns being filed, as account holders have been forced to declare previously hidden money to the authorities.

Last year’s introduction of a national goods and services tax has also helped boost the number of people and businesses filing returns.

Under the new system, every business, down to the smallest market stall, must register for the tax if it wants to claim tax credits on its supplies. As a result, the number of businesses registered to pay indirect tax has risen more than 50 per cent to about 10m.

So far, GST collections have not been as high as the government had hoped, indicating that many of the new registrants are falling below the threshold to pay it. 

But merely the fact that they have had to register means that many small business owners are now no longer able to hide their income from the tax authorities. Partly as a result, the number of personal income tax returns filed in 2017-18 jumped by 26 per cent.

“There has been an increase in tax compliance — that is being seen in the number of firms registered for GST and a big pick up in income tax collection,” said Sonal Varma, an analyst at Nomura.

While the overall number of individuals registered for tax remains low at just 61m in a country of 1.3bn, the 2018 economic survey estimates demonetisation and GST alone have already contributed to an additional 1.8m registrations.

Arvind Subramanian, the government’s chief economic adviser, said he thought the flood of new tax filers should boost the country’s tax-to-GDP ratio by 1.5 percentage points over the next two to three years.

The benefits could be undone if the government chooses to raise the minimum salary for paying income tax, as previous governments have often done. But Arun Jaitley, the finance minister, chose not to do so in the last Budget, and Mr Subramanian has said: “I don’t think we’re going to err on that again.”

He told the Financial Times: “Having a consistently buoyant source of revenue will help the fiscal outlook in the medium term, and can provide more room for spending on human capital such as health and education.

“But more importantly, the more people pay tax the more people feel a connection with the state. It provides a democratic boost as well as an economic one.”

He added: “What India has done especially with the complexity and scale of the GST offers a model for other developing countries.”

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India shows neighbours the way out of tax trap

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