ASCI Journal of Management 40(2): 128138 Copyright 2011 Administrative Staff College of India

SUNIL MITRA*

The Indian Tax System and Its Reform*

A strong tax system is fundamental to the development of a nations economy. Taxation is, however, about significantly more than revenue mobilization. The manner in which taxes are administered and collected, and the uses to which they are put, define the symbiotic relationship between the state and its citizensstrengthening the former, while making it necessarily more accountable to the latter. In India, the tradition of taxation has been in force in one form or another from ancient times. The word kara, which refers to taxes, finds mention in the Srimad Bhagvatam. When Chanakya aphorised in the Artha Shastra, Kosha moolo danda, he made the important point that the treasury and its inflows are the sources of a governments might. Indeed, the Sanskrit word danda, which translates to the sceptre, is the manifest form of a governments identity, consciousness and conscience. Manu, the ancient sage and law-giver, laid down that traders and artisans should pay one-fifth of their profits in silver and gold; while agriculturists, depending upon their circumstances, were to pay one-sixth, one-eighth or one-tenth of their produce. Kalidasa in the Raghuvansha says thus of King Dileepa: It was only for the good of his subjects that he collected taxes from them, just as the Sun draws moisture from the Earth to give it back a thousand fold. In his book Public Finance in Ancient India, the learned author K. B. Sarkar commends the system of taxation in ancient India: Most of the taxes of Ancient India were highly productive. The admixture of direct taxes with indirect taxes secured elasticity in the tax system, although more emphasis was laid on direct tax. The tax structure was a broad-based one and covered most people within its fold. The taxes were varied and the large variety of taxes reflected the life of a composite population.
Finance Secretary, Govt. of India. Public lecture delivered at the Administrative Staff College of India (ASCI), Hyderabad, on 17 June 2011.
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In the medieval period, the Sultans of Delhi collected taxes under five main categories. The Mughal emperors granted land revenue rights to a mansabdar in exchange of promises of soldiers during wartime. The Treaty of Allahabad of 1765 gave the British and the French the right to collect taxes on behalf of the Emperor. Thus, the British system of collectors of land revenues was firmly established well before the disintegration of the Mughal Empire after 1857. Public administration in India during the latter half of the nineteenth century saw large shifts and overhauls in its structures and processes. In July 1860, James Wilson, the first Finance Member of the Governor-General-in-Council, quoted thus from the authority of Manu while introducing the act for levying income tax in the country, As the leech, the calf and the bee take their food little by little, even so must the King draw from his realm, moderate annual taxes. As we proceeded through this century, the financial obligations of the Raj increased, and the need to revamp the tax system was felt. In 1919, with the introduction of the federal structure through Diarchy, taxes on income and some other taxes were made a central subject. In 1922, a paradigm shift occurred with the enactment of a new Income Tax Act that led to the setting up of a comprehensive taxation system with its own administrative machinery. In 1924, a Central Board of Revenue was created to administer central taxes. The attainment of Independence marked another paradigm shift for taxation. The objective of collecting revenues was no longer the preservation or advancement of British interests. After a long hiatus, Indians were going to pay taxes for their own welfare, thus redefining the role of taxation in the country. Indias tax system is based on the assignment of separate taxation rights to the Parliament in the Centre and to the legislatures in the states. These taxation powers are contained in List Ithe Union List and List IIthe State List of the Seventh Schedule to the Constitution of India, read with the relevant articles that provide the substantive power to levy and collect taxes. The evolution of the tax system over the last 60 years reflects the changes in Indias development strategy, tax legislation, the institutional structure of tax administration and the role of information technology. The subject of my presentation before you this evening will attempt to trace the initiatives for tax reform in India over the last decade. The major direct taxes levied by the Centre are tax on personal and corporate incomeexcluding tax on agricultural income for which the authority to levy tax is with the statesand wealth tax. The indirect taxes levied and collected

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by the Centre are Central Excise Duty, customs duty and service tax. A fixed proportion of the taxes collected by the Centre devolves to the states, based on the recommendations of the Central Finance Commission, which is set up every five years to review this sharing mechanism. Presently, 32 per cent of the revenue collected from these taxes is transferred to the states through devolution under the advice of the 13th Finance Commission. The inter se share of different states is also determined on the basis of their recommendations. Although the tax base of the states is variegated, the mainstay of tax revenues for the state governments is the Value Added Tax, or VAT, which is levied upon intra-state sale of goods. Sales tax is levied by the states on a few special category goods, such as petroleum and tobacco. The other important taxes levied by the states are the state excise on the production, distribution and import into the state of alcohol and alcoholic liquor, and of opium and Indian hemp; luxury tax; entry tax; taxes on the transportation of goods and passengers; electricity duty and entertainment tax. Stamp duty, taxes on land and buildings, tax on agricultural income, and the professional or employment tax are the other taxes that the states are empowered to levy. Taxation has been an important component of the central governments policy on macro-economic management, especially economic growth and its distribution. The tax policy has also been reviewed and guided at different stages by the reports of expert committees on tax reform instituted by the Government of India. These reports are a useful guide to the challenges faced by the countrys tax system and the responses to them over the last six decades. Another important source for analysis is the revenue foregone statement in the receipts budget, which has been tabled as part of the budget documents since 2006. Before I begin my presentation on the two discrete components of the Indian tax system and their reform, let me present before you the biggest dilemma of all tax planners. They flow from the following maxims:
A robust and efficient taxation system is the foundation of a successful economy and a pre-requisite for sustainable growth. But despite the benefits that an efficient and well-managed taxation system brings, it is rarely perceived as a constructive phenomenon. The language associated with tax has become highly negative. Tax is presented as a burden from which, we all need relief. Tax increases have never been popular, and all governments have had difficulty in formulating an effective tax policy. The perception of Thomas Aquinas from the thirteenth century that taxes are a form of legal plunder has been so persistent that no government has been able to change it entirely. Despite all

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the advantages that taxation brings to society, it has been difficult for any government to dislodge the perception that it is either set too high, is being spent ineffectively, or that it is being directed towards the wrong outcomes.

An American humourist has said that standing up in front of a group of people and trying to explain the tax law is a good way to become a social outcast. Ladies and Gentlemen, if you think it is hard to listen to someone explaining the tax law, you should try reading it sometime! Direct Taxes Over the years, the direct tax policy has been used to attempt to encourage savings and investment, reduce inequalities of income and wealth, and promote investment in underdeveloped regions and in specific priority sectors. These objectives have been tempered by the need to enhance the ability of the tax system to raise revenues with minimum distortion in the economic decisions of taxpayers. Over the last decade, the emphasis has been on the lowering of tax rates to moderate levels, while simultaneously broadening the tax base by weeding out exemptions and by using information technology to ensure compliance in the reporting of financial transactions. A broad base with lower rates is desirable from a public policy perspective because elimination of exemptions and concessions reduces administrative and compliance costs as well as expectations of special treatment by different sectors of the economy. It also allows the tax administration to concentrate its resources in areas that need a higher level of enforcement rather than on monitoring and litigating complicated tax preferences. This provides stability and simplicity to the tax system in a developing, high-growth economy like India. Indias development strategy in the first decades after Independence was based on rapid industrialization through centrally planned and import substituting growth in heavy industry owned by the public sector. Scarce resources were to be channelled for this purpose, and the belief was that manufacturing capacity needed to be regulated and licensed to avoid wastage of resources. The tax system was therefore tasked with raising resources for the large and increasing requirements of public consumption and investment while also achieving redistribution of incomes. This resulted in very high rates for both personal income tax and corporation tax. In 1974, the personal income tax had as many as 11 tax brackets, with rates rising from 10 to 97.5 per cent, including surcharges. If the rates had climbed any higher, they would have gone into orbit! In the case of corporates, a distinction was made between widely and closely held companies and the tax rate varied from 45 to 65 per cent.

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The pursuit of a multiplicity of objectives complicated the tax system with adverse consequences for its efficiency and equity. Central planning priorities dictated and legitimized selectivity and discretion in tax policy and administration. Lack of an adequate information system hampered the implementation, monitoring, review and evaluation of the discretionary elements of the tax system. Consequently, the system was faced with challenges of an increased incentive to both avoid and evade taxes in a low probability detection and ineffective implementation regime that failed to impose penalties within a reasonable time period. Different tax enquiry and reform committees were constituted to tackle these systemic anomalies. In keeping with their recommendations, the marginal tax rates and number of slabs for personal income tax were substantially brought down in phases, commencing in 1975, from a low rate of 10 per cent and a high of 97.5 per cent to the present 10 to 30 per cent. The number of tax brackets was also been brought down from 11 to only 3. In the case of corporates, the distinction between closely held and widely held companies was scrapped in 1995, and the rates were moderated from 45 to 65 per cent in 1974 to the present base rate of 30 per cent. While moderating the rates, the challenge has also been to rationalize the tax incentives. The expert committees took stock of the exemptions and concessions that had evolved over the years and served to erode our tax base. In respect of personal income tax, the first reform in moderating tax preferences was undertaken in 2006 with the phasing out of tax rebates on a variety of investments and allowing them, instead, as a deduction from the taxable income subject to a cap. In the case of corporates, the major tax incentives comprised profit-linked deductions for specified sectors and underdeveloped areas. To broaden this tax base, a Minimum Alternate Tax (MAT) was introduced in 1997 in the case of a differential between the tax on corporate income after availing the incentives and the tax at a specified rate (MAT rate) on the book profit reported by a company to its shareholders. In later years, companies paying MAT were allowed to take a partial credit against their tax liabilities in the subsequent years. The overall MAT rate has been enhanced from 11.33 per cent in 2006 to 20 per cent in 2011, thereby ensuring a threshold level of tax payment by all corporates irrespective of tax incentives. As India increasingly looks to develop, and attract funds for, its capital market, capital gains from its listed securities held for over a year have been exempted from tax for both domestic and overseas investors. A separate Securities Transaction Tax at the rate of 0.125 per cent on both the purchase and sale of

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equities on stock exchanges is levied, however, since October 2004. This measure ensures a steady and administratively simple means of collecting a minimum level of tax through the stock exchanges. The increased use of information technology has enhanced the efficiency of the tax administration in providing taxpayer services as well as in monitoring and reporting financial transactions in order to bring them to tax. The use of a unique taxpayer identity number, extensive use of tax deduction at source, electronic reporting by registering authorities of transactions in real estate, banking and other transactions, electronic payment of taxes, electronic filing of returns, and the establishment of the Tax Information Network have strengthened both voluntary compliance as well as the enforcement mechanism. Electronic filing of tax returns by companies has ensured a higher level of monitoring and compliance; and since 2006 has also resulted in a detailed analysis of the revenue foregone on account of direct tax incentives. These measures, along with a rapid growth in GDP, have resulted in a steady rise in the direct tax-to-GDP ratio. For the first time in recent decades, the Union governments direct tax collections exceeded the indirect tax collections in 2008, indicating a structural change towards a more progressive tax structure. In 2010, the overall tax-to-GDP ratio for the Centre and the states stood at a combined level of 16 per cent. It is often said that the only thing that you can be sure of about the weather or the tax laws is that they will change. The Income Tax Act, 1961, that replaced the pre-Independence Indian Income Tax Act, 1922, has been in effect for almost 50 years and has been amended by as many as 34 discrete amendment acts besides as many as 51 annual finance acts. These were required due to policy changes caused by the changing economic environment, increasing sophistication of commerce, increase in international transactions as a result of globalization, development of information technology, attempts to minimize tax avoidance and in order to clarify the statute in relation to judicial decisions. As a result, the basic structure of the Income Tax Act has become overburdened and its language has become excessively complex. In order to revise, consolidate and simplify the language and structure of the direct tax laws, the draft Direct Taxes Code (DTC) Bill, 2010, along with a discussion paper, was released in August 2009 for public comments. It is proposed to replace the Income Tax Act, 1961, and the Wealth Tax Act, 1957, by a single code. In what has been a truly participative legislative process, over 1,600 sets of comments from a wide range of stakeholders were analyzed; and valid concerns were responded to in a revised discussion paper that was released

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in the public domain in June 2010. The Direct Taxes Code Bill was introduced in Parliament in August 2010 and is at present, under examination by Parliament. The DTC attempts to consolidate and integrate all direct tax laws; simplify the language by using direct, active speech; usher in stability in the tax rates by incorporating them in a schedule to the code and not through annual legislation; strengthen taxation provisions for international transactions; phase out profitlinked tax incentives and replace them with investment-linked incentives for priority sectors. The ongoing challenges in building a strong direct tax policy regime primarily relate to strengthening tax administration, integrating information technology in its functioning and reducing tax litigation. Indirect Taxes The year 1991 was a watershed in the history of indirect taxes in India. Triggered by a serious balance-of-payments position and the consequent financial crisis, a process of far-reaching reform, guided by the recommendations of the Tax Reforms Committee 1991, chaired by Mr. R. J. Chelliah, was initiated. Until then, the efficiency of the indirect tax system and compliance levels were severely compromised by very high rates of duty, coupled with a large number of exemptions for meeting a variety of socio-economic objectivesdriven by policy imperatives similar to those on the direct taxes side. Unduly high dependence on import duties as a source of revenue was also a characteristic of the system. Such a tax structure was not conducive to high growth as it engendered a high-cost economy riddled with tax cascading. It also did not raise adequate revenues commensurate with the tax rates and effort, thereby having a deleterious impact on the health of public finances. With the inception of reform, the effort has been to broaden the base and lower the ratesin keeping with the policy shift in the case of direct taxes. Among the achievements of the reform process, the most critical has been the shift in the respective shares of direct and indirect tax collections in the gross tax revenues of the Union government. Within indirect taxes, the contribution of border taxes or customs duties has fallen considerably compared to domestic taxes or central excise duties and service tax. Reduction in the share of customs duties is even more pronounced if revenues from additional customs duties (commonly known as countervailing duties and special CVD), which are meant to counterbalance excise duty, state VAT, Central Sales Tax, and other local taxes and charges, are included in the

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revenue collection from domestic taxes. This is due to the opening up of the economy and a dramatic reduction in customs tariffs with a view to improving the competitiveness of domestic manufacturing. Remarkably, this shift in the composition of tax revenues, towards direct taxes on the one hand and domestic taxes on the other, has occurred despite a steep moderation in the rates of these taxes. It is evident that there has been considerable improvement in tax compliance over this period, both as a consequence of rate reduction as well as the efforts made to strengthen tax administration. The best tax policy in the world is worth little if it cannot be implemented effectively. Information technology has been deployed extensively to reduce the physical interface between the taxpayer and the IT Department. With the automation of all major locations, customs administration works now, almost entirely, on the Electronic Data Interchange (EDI) system. Filing of import and export documents, and their processing and tracking are conducted electronically. The adoption of ACES (Automated Central Excise and Service Tax), for the other two taxes, has simplified the processes of registration, return filing and tax paymentsall of which can now be transacted electronically. Self-assessment of tax liability by the taxpayer, followed by risk-based selection for scrutiny or audit, is the mode of tax collection for all these taxes. Internal work processes have also been revamped to impart greater efficiency in key processes such as scrutiny and audit. The other achievements of the reform process comprise imposition of service tax and a gradual widening of its coverage; inclusion of capital goods within the ambit of the input credit scheme; and more effective tax neutralization so that the duties paid on inputs may be neutralized by a service provider and the tax paid on input services, by a manufacturer of goods. State taxes have also been a focus of attention in our reform programme. Prior to 2005, the states were dependent primarily on sales taxes for raising revenues. Sales tax was applicable to intra-state sales. The Central Sales Tax applies to inter-states sales. This tax is levied by the Centre but collected and appropriated by the states. The process of replacement of the sales tax with state Value Added Tax, or VAT, began in 2005 with 22 states opting for this transition. By December 2008, all the states had completed this transition. The adoption of VAT, which applies to the entire value chain for goods, starting from premanufacturing to retail, has had a very positive impact in mitigating double taxation and cascading. Rate wars among the states witnessed under the sales tax regime have ended, and dispersion in rates has been reduced with dual

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rates. The rate of the Central Sales Tax has been brought down from 4 per cent to 2 per cent. Coupled with administrative re-engineering in many states, this reform has generated considerable revenue efficiency, with almost all the participating states registering double-digit growth in revenue collections. Although far-reaching, these reforms have not completely eliminated the deficiencies or inefficiencies in the Indian tax system. There are still a large number and variety of indirect taxes, especially among those levied by the states. Examples are: sales tax on crude petroleum and petroleum products, state excise on alcoholic liquor for human consumption, entry tax, octroi, entertainment tax, taxes on lotteries and gambling, luxury tax, electricity duty, taxes on the transportation of goods and passengers. In addition, both the Centre and the states levy cesses and surcharges that are meant to generate resources for a particular purpose. Most of these apply to a narrow tax base and are therefore non-VAT type of taxes; input tax credit is not permitted. This generates cascading and double taxation at many points in the value chain for the production and distribution of goods and services. The upshot is that the tax system creates distortions and anomalies for domestic manufacturing and trade. It has an adverse implication for the export of goods and services in as much as it does not allow full zero-rating of exports. Moreover, it is wasteful of administrative resources as a separate administrative mechanism is required for the collection of many of these taxes. Such an administrative structure has made it near impossible to optimize tax compliance through the exchange of information about a taxpayer across tax jurisidictions. For the taxpayer, the compliance cost is high as s/he has to deal with multiple tax authorities. The Goods and Services Tax (GST) will mark a very significant improvement over the existing system, as it will integrate the tax base across the value chain of supply of both goods and services in the economy. Not only will this enable the taxation of each stage of the value chain at a uniform rate, it will also enable the seamless pass-through of input tax credit so that the incidence is effectively borne at the stage of final consumption of goods and services. It is well accepted that such a tax system minimizes distortions in economic choice. The Empowered Committee of State Finance Ministers released its First Discussion Paper on the Goods and Services Tax in November 2009. This spelt out the features of the proposed GST and has formed the basis for discussion between the Centre and the states so far. The paper envisages a destination-based, dual GST with the Centre and the states simultaneously

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levying it on a common base. This tax will replace several indirect taxes currently levied by the Centre and the states, including Central Excise Duty, service tax, state VAT and Central Sales Tax. Input credit would flow seamlessly across the value chain in both the central and state components but not across these two taxes. Exports would be zero-rated. It will apply to all services barring a few to be specified. A common threshold exemption will apply to both the central and state components, and dealers with a turnover below it will be exempt from tax. An Integrated GST (IGST) would be levied on the inter-state supply of goods and services. This tax will be collected by the Centre so that the credit chain is not disrupted. Accounts will be settled periodically between the Centre and the states to ensure that the state GST component is transferred to the destination state where the goods or services are eventually consumed. As I have mentioned at the outset, the distribution of fiscal powers between the Centre and the states is enshrined in the Constitution of India. For GST to be introduced, this distribution needs redefinition so that both the Centre and the states may concurrently levy this tax. Based on the status of discussions so far, the Centre and the states have jointly prepared a draft GST Constitutional Amendment Bill for this purpose. This bill was introduced in the Lok Sabha in March 2011. It needs to be passed by a two-thirds majority in both Houses of Parliament and subsequently ratified by at least half of the state legislatures. It is only after the enactment of this bill that suitable legislation for the actual levy of GST can be introduced either in Parliament or in the state legislatures. Apart from forging a consensus on the constitutional amendment that will create the legal framework for the levy of GST, the administrative challenges in its implementation are quite formidable. The central and state governments will be required to collaborate closely, and not compete, for the first timenot only in raising tax revenue but also in formulating tax policy in a harmonized manner through the GST Council. There is likely to be a significant increase both in the number of taxpayers as well as their size and complexity. The expectation of the taxpayer community will be of high-quality service delivery by the respective tax departments so that the compliance burden may be minimized. Above all, they will look for a similar experience and treatment at the Centre and across the states. For this to happen, business processes across the two have to be completely harmonized and a single point of contact has to be made available to the taxpayer. The Centre and the states are agreed that this will, in turn, require a very strong IT infrastructure. They have already set in motion the process of designing and implementing the GST Network (GSTN) through a special purpose vehicle owned jointly by the Centre and the states

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and for the present, incubated in, and later assisted by, a technology partner. The GSTN is being created under the guidance of an Empowered Group chaired by Dr. Nandan Nilekani. In addition, the key business processes for the two tax administrations are being jointly designed. And we expect to validate, next month, the concept of a single portal handling registration, returns and payments across the country, in a pilot project comprising the Centre and as many as 11 states. Finally, the efficient roll-out and implementation of GST will require the pooling of intellectual and human capital by the Centre and the states and a very robust coordination mechanism for conducting their day-to-day activities. Apart from taking the reform process further, the two initiativesthe introduction of the Direct Taxes Code and the Goods and Services Taxpresent a great opportunity for synergizing the tax efforts of the central and state governments. In terms of timing, they are almost synchronized. Besides, they are being launched at a juncture when the IT component of the tax administration at the Centre as well as in many of the states has already been substantially strengthened. I will conclude by highlighting two critical aspects of the important reform process that is now at hand. These are more in the nature of overarching themes that straddle initiatives in both the tax systems. Both these aspects are inextricably intertwined. The first is the definitive transformation in the basic role of our tax administrationfrom being an enforcement-driven system, it is being to transformed into a system driven by a facilitation motive, imbued with the spirit of providing service to the taxpayer community. The second aspect, seemingly contradictory but equally critical to the integrity of the reform effort, is to remain steadfast and firm in weeding out exemptions or incentives that are distortionary and have caused shrinkage in the tax base. Government has to be firm in this resolve despite it being unpopular as it affects the status quo. The measures taken to phase out the distortionary area-based exemptions and the profit-linked deductions for the software technology parks of India (STPI) and other special economic zones have to be viewed in this perspective. The imposition of MAT on SEZs is to be understood as a measure for the preservation of the tax base by ensuring a minimal rate of tax for all corporates. The governments unwillingness to allow any further extension in the validity of the Duty Entitlement Passbook (DEPB) Scheme, beyond the three-month period necessary to work out the duty drawback terms, is also a measure aimed at protecting the tax base. As they say, the road to excellence is always under construction! Thank you for your patience.