Rethinking India’s tax system

Rethinking India’s tax system
Indian states should rely more on property tax, which is economically efficient, incentive compatible, and progressive
There is a fundamental problem with India’s current tax system. India simultaneously has a tax base for direct taxes that is too small; and a tax base for indirect taxes that is too large. Consequently, too little tax revenue is raised; and too much of the tax burden is paid by the poor. This limits the state’s ability to provide the infrastructure and manpower required for good governance.

According to the December 2017 report of the income-tax department, only 1.6% of Indians pay income tax. This is unsurprising since agricultural income is not taxed in India and the wealthy have mastered the art of tax avoidance and evasion.

Despite the small base for income tax, most Indians contribute to tax revenue because India relies heavily on indirect taxes. However, the Indian version of taxing consumption is not very efficient. Even the relatively incentive-compatible goods and services tax (GST) is fraught with high compliance costs, too many rates and classifications.

Further, taxes on consumption tend to be regressive, because poor people spend a greater proportion of their income on consumption—and consumption is taxed at high rates in India. The regressive nature of a consumption tax is exacerbated by the current GST system, where biscuits are taxed at 18% but gold is taxed at only 3%. For instance, the smallest packets of Parle-G biscuits, a snack for the middle class, and often a meal substitute for the poor, are priced at Rs2 and Rs5, with an 18% tax. While the price is unlikely to increase, the quantity available to the buyer will likely reduce at that price—with tax burden partly passed on to the consumer.

So, what can be done to resolve this problem? I propose that Indian states should rely more on property tax, which is economically efficient, incentive compatible, and progressive. Property tax has four key benefits.

First, it is difficult to evade. Property cannot be moved, or hidden easily, and lasts long. There is an additional incentive to correctly declare the full extent of one’s property. Property owners will not understate the amount of property owned, because it might adversely affect their wealth, future sales, disputes, inheritance, etc. Since property often forms a large proportion of total assets/wealth, there is a built-in incentive to declare property honestly, unlike incentives to understate income or sales.

Second, property tax is efficient because it creates fewer distortions. Typically, a tax on something results in less of it. High levels of income tax may create a disincentive to work. High sales taxes may lead to lower consumption, and, in certain situations, an informal economy, with goods sold off-the-books, etc. In this regard, property taxes are quite efficient. Typically, existing buildings, land, etc. don’t reduce or disappear because of a tax. The main response available to the property owner is to sell the property, and as long as there is a buyer willing to take on the tax burden, revenue tends to be stable.

Third, property taxes tend to be more progressive than consumption taxes (but less progressive than income tax) because the wealthy, relatively, own more property. India has a very high percentage of home ownership, especially in rural areas. It will be important to design a progressive property tax system by classifying plot sizes, accurate land values and zoning data.

Finally, and most importantly, property taxes tend to be levied by local governments. This creates a very direct feedback mechanism between voters/taxpayers and their elected representatives, unlike income and sales taxes, which are levied centrally and spent far from where they are collected. In India today, the urban rich and middle class are able to exit the consequences of state dysfunction by buying into gated communities and private developments. Within these communities, individuals pay maintenance fees, which provide the same services that would be provided by a functional municipal system.

A property tax system makes such exit costlier— which might lead the rich and middle class, who have political and social capital, to participate in governance decisions and demand better public goods and services. Unlike income taxes (often withheld at source by the employer) or sales tax, where the tax is hidden in the retail price, taxpayers typically have to write a cheque to the government while paying property tax. This has the advantage of revealing the extent of the tax explicitly, which may lead taxpayers to demand low tax rates as well as exert pressure on local governments for better services.

Property taxes may also have other consequences specific to India, with its 24.7 million vacant homes. Much of the black money in India is channelled towards owning multiple homes, and poorly designed tenancy laws coupled with a slow dispute resolution system incentivise owners to leave additional homes vacant. Property taxes make it costlier for owners to have additional vacant properties that are purely speculative. In rural India, property tax may also be an avenue to tax wealthy farmers without unduly burdening poor farmers, since agricultural income is not taxed at all.

Currently, India barely relies on property taxes, with a property tax to gross domestic product (GDP) ratio of 0.2%. For other developing countries, though data varies greatly, the rough estimate is 0.7%. By comparison, the average property tax to GDP ratio for OECD countries is almost 2%. India should actively consider exploring property taxes as an important source of revenue to develop increased citizen participation for public goods infrastructure.