Moving back to a regressive tax system

The Swachh Bharat cess imposed by the Narendra Modi government is part of a continuum of moves that is making the Indian tax system even more regressive.

Let us rewind to 1991. Socialist India had one of the most regressive tax regimes in the world. Four out of every five rupees collected as tax by the government came from indirect taxes, which are considered regressive because their burden is shared by citizens irrespective of income. This was one of the less noticed hypocrisies of successive socialist governments that taxed the poor even while pretending to serve them. One of the key goals of the subsequent tax reforms was to make the tax system more progressive by increasing the importance of direct taxes.

The tax reforms of the early 1990s were an eventual success on this front. More moderate tax rates, a cleaner tax system with fewer exemptions and better tax administration helped. The share of direct taxes in the total kitty steadily went up over the years. Corporate taxes led the increase. An important inflection point was reached in fiscal year 2009, when the share of corporate taxes became higher than the share of indirect taxes, for perhaps the first time in our fiscal history. The Indian tax system finally became more progressive.

There are now disturbing signs that the process is reversing. A story by the Mint data journalism team in May showed that the share of indirect taxes have gone up by six percentage points since fiscal 2010 while the share of direct taxes began to come down by the same proportion. Direct taxes still dominate—by eight percentage points—but it may be a matter of time before the clock is turned back.

Part of this problem is undoubtedly because of the sluggish growth in corporate taxes as a result of the pressure on profits in recent years. There was a splendid surge in corporate tax collections during the four years of unprecedented economic expansion after 2004. Then the financial crisis stopped Indian companies in their tracks. So it is fair to assume that there will be a recovery in corporate tax collections once the economic recovery gathers steam. Meanwhile, the drop in input and financing costs could support corporate profits in the coming quarters. The business cycle may thus explain some of the reversal seen in recent years, but the recent tax decisions by the government are a much deeper cause for worry.

The finance ministry has clearly depended on indirect tax hikes to support its revenues, which is one of the main reasons why the latest budget numbers for this year show a robust growth in indirect taxes compared to sluggishness in direct tax collections. Some of these tax hikes, especially on energy, are justified because they reverse some of the tax cuts by the previous government when global oil prices were shooting up, and because more expensive energy can help India meet some of its climate change commitments.

Yet, the bottom line is that indirect taxes grew by 36.9% in the first seven months of the current fiscal year, partly because of the pick-up in economic activity but largely due to higher tax rates (which is one reason why gross domestic product at market prices came down in the first quarter even as gross value added accelerated).

There have been several criticisms of the Swachh Bharat cess—from its impact on fiscal federalism to the distortions it will introduce at a time when India wants to move to a single goods and services tax (GST). These are valid criticisms. An equally important worry is that the cess is the latest in a series of tax moves that will make the tax system less progressive. It is a worry that goes beyond the usual budget calculus or even the denial of revenue to states.

Is Swachh Bharat cess a good idea for the Indian tax system?