UNIT 11 DIRECT TAXES

Structure
11.0 Objectives
11.1 Introduction
11.2 Canons of Taxation
11.3 Direct Taxes and Efficiency
11.4 Approaches to Tax Equity
11.4.1 Benefits Received Approach
11.4.2 Ability to Pay Approach
11.5 Proportional vs. Progressive Taxes
11.6 Taxation of Capital
11.7 Laffer Curve
11.8 Tax Evasion
11.8.1 Allingham-Sandmo Model
11.9 Indian Tax Structure
11.9.1 Tax-GDP ratio of the Central Government
11.9.2 Marginal Tax Rates and Exemption Limit
11.9.3 Tax Reforms
11.9.4 Tax Evasion in India
11.10 Let Us Sum Up
11.11 Key Words
11.12 Some Useful Books
11.13 Answers/Hints to Check Your Progress
11.14 Exercises
11.0 OBJECTIVES
After going through this unit, you will be able to:
appreciate the basic principles of taxation;
look into the efficiency and equity aspects of direct taxation;
appreciate the difference between proportional and progressive direct taxes;
understand the issues involved in capital taxation;
understand basic model of tax evasion;
get an idea about the main features of Indian Tax Structure; and
get an idea about the direction of reforms in direct taxes in India.
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29
11.1 INTRODUCTION
Tax is a compulsory levy imposed on economic units by the government. Taxes are
generally divided into direct taxes and indirect taxes. Direct taxes are those which
are levied directly on the entity meant to bear the burden. In the case of indirect
taxes the tax burden is shifted from where they are initially imposed. In India, Personal
Income Tax and Corporate Income Tax are the important direct taxes levied by the
central government.
11.2 CANONS OF TAXATION
A good tax system should possess the following characteristics:
a) Revenue Adequacy Governments levy taxes to finance their expenditures.
Therefore, a good tax system should generate adequate revenue for the
government.
b) Equity The tax burden should be distributed in an equitable manner.
c) Efficiency The tax system should not interfere with the efficient allocation of
resources.
d) Administrative Simplicity The tax structure should be simple to administer.
Also the cost of collection should be the minimum. Simplicity of the tax structure
would also help in checking evasion.
e) Transparency The levying of taxes and the spending of tax proceeds should
be done in a transparent manner. The tax structure should be such that its
incidence should be clear.
In the following two sections, the principles of efficiency and equity are discussed in
detail in the context of direct taxes.
11.3 DIRECT TAXES AND EFFICIENCY
A Pareto efficient allocation of resources is defined as one from which no economic
agent can be made better off, without making someone else in the economy worse
off. Mainstream economic theory teaches us that in a system where each economic
agent maximizes its objective function subject to the constraints (e.g. individuals
maximize their utility subject to their budget constraint and firms maximize their profits)
and given certain other assumptions, free operation of market forces would lead to
a Pareto efficient allocation.
Imposition of a tax in such a system would alter the relative prices. The price signals
would be distorted, thus affecting the choice of the economic agents and altering the
allocation of resources. For example, with the imposition of sales tax, the slope of
the consumers budget line changes and his equilibrium position is changed. The
economic agent would try to minimize the payment of the tax by reducing the
consumption of the commodity which is taxed. Therefore, the weight of different
commodities in the consumers consumption basket is changed.
In the case of an indirect tax, the distortionary effect is clear. The distortionary effect
of direct taxes is less apparent than that of indirect taxes. Let us consider the effect
of income tax. An income tax does not alter the relative prices of the commodities
but it affects the individuals choice between income and leisure.
Economics of Taxation
30

Income
A

C
E

A
1

E
2
I
1


I
3

E
1

G
1

I
2





O M

M
2
M
1
D B Leisure
Fig. 11.1
Fig.11.1 illustrates this tradeoff. The X-axis represents leisure and the Y-axis income.
OA is the maximum income the individual can earn if he spends the entire time
working (say, 24 hours a day) and OB is the maximum leisure the individual can
enjoy if he doesnt work at all. The wage rate is OB/OA. The individuals equilibrium
is at point E, where his leisure is OM and work effort is MB. He earns an income of
EM.
Imposition of an income tax moves the budget line to A
1
B and the individuals
equilibrium shifts from E to E
1
. His work effort falls from MB to M
1
B, whereas
leisure increases from OM to OM
1
. Therefore the imposition of an income tax induces
the individual to reduce his work effort. The individual reduces his work effort to
reduce his tax payment. This is the distortionary effect of an income tax. Had the
same amount of revenue been collected by a tax on a base which includes leisure as
well, the budget line would have shifted from AB to CD and the individuals new
equilibrium would be E
2
. Here the reduction in work effort would be less MB to
M
2
B.
Therefore direct taxes also create inefficiency in the allocation of resources. In this
sense, most taxes are distortionary. A tax would be non-distortionary only if the
economic agents cannot avoid it by changing their behaviour. Such taxes are called
lump sum taxes.
Head tax is an example of a lump sum tax.
Check Your Progress 1
1) What are the canons of Taxation?
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31
2) How does the imposition of a tax distort the allocation of resources?
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11.4 APPROACHES TO TAX EQUITY
Equity or fairness should be the essential feature of any tax system. It is widely
agreed that the burden of taxes should be distributed in an equitable manner. But for
designing a tax structure, the concept of equity needs to be properly defined. Two
approaches are generally used:
11.4.1 Benefits Received Approach
A major motive for collecting taxes is to finance the provision of public services.
Therefore, the proponents of Benefits Received Approach argue that the individuals
should contribute to government revenue according to the benefits they receive from
public services. So it provides a clear link between the benefits received by the
people from the services and their contribution towards their provision. It also solves
the problem of determination of the quantity and form of public services.
However, there are certain drawbacks to this approach. It cannot be applied when
taxes are levied for redistributive purposes. Ideally this principle should apply only
to those taxes which are used to finance public services. But in practice, such a
separation of taxation for public services and taxation for other purposes is rarely
done. This approach is not much applicable for direct taxes.
11.4.2 Ability to Pay Approach
The ability to pay approach is more relevant for direct taxes. It states that individuals
should contribute towards government revenue according to their ability to pay.
Income, consumption, wealth etc., could be used as the indicators of the ability to
pay of individuals.
A tax system, which follows this approach, should adhere to two principles of equity
Horizontal Equity and Vertical Equity. The former states that individuals with equal
ability to pay should pay equal taxes whereas according to the latter principle those
who are in a position to pay higher taxes i.e., those with higher ability to pay should
pay more than those with lower ability to pay. Taking income as the index of ability
to pay, this means that individuals with higher income should pay more taxes than
those with lower incomes.
The ability to pay approach provides the guiding principles for designing an equitable
tax structure. But how much should people at different income levels pay so as to
adhere to the principle of vertical equity? It is argued that tax payments should lead
to equal sacrifice of welfare by the individuals. There are three rules of this equal
sacrifice principle. They are discussed below with the help of Fig.11.2.
Assuming utility represents the welfare of the persons, the sacrifice in welfare is
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32
measured using the individuals marginal utility of income schedule. It is also assumed
that MU schedule is known and identical for all individuals. In Fig.11.2, Panel A
shows
Low Income Person
Marginal Utility
of Income






G
E

C
A
MU
L





O H F D B Income
High Income Person
Marginal Utility
of Income








C
1

E1
G
1


A
1

MU
H



O D
1
F
1
H
1
B
1
Income
Fig. 11.2
the Marginal Utility schedule of low-income person and Panel B shows that of the
high-income person. In both the panels, X-axis represents the income of the individual
and Y-axis represents the marginal utility of income. The low-income person has an
income of OB whereas the high-income persons income is O
1
B
1
. The three principles
are:
i) Equal Absolute Sacrifice According to this rule each person should sacrifice
the same amount of utility. In the figure, under this rule, the low-income person
would pay HB and suffer a loss of utility of HBAG while the high-income
person would pay H
1
B
1
and would sacrifice H
1
B
1
A
1
G
1
and HBAG =
H
1
B
1
A
1
G
1
. Total tax revenue, TR =HB +H
1
B
1
. If the marginal utility were
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constant, the tax structure would be regressive, as individuals would be paying
the same amount as tax. For declining MU schedule, this rule would call for a
proportional tax structure if the elasticity of marginal utility of income with respect
to income is unity. It would call for a progressive tax structure if the elasticity is
greater than unity and for a regressive structure if it is less than unity.
ii) Equal Proportional Sacrifice This rule suggests that the proportion of
sacrifice in utility to pre-tax utility would be the same for all individuals. In
Figure 2, the low-income individual would pay FE and the high-income individual
would pay F
1
E
1
. The proportion of utility sacrificed by the former (FBAE /
OBAM) is equal to that sacrificed by the latter (F
1
B
1
A
1
E
1
/O
1
B
1
A
1
M
1
). If MU
is constant a proportional tax is called for. But for declining MU schedules, one
has to compare it with average utility. The tax structure is progressive if the
decline in marginal utility is greater than that in average utility and is proportional
if both schedules fall at the same rate. If the marginal utility declines at a rate
lower than that in average utility, a regressive tax structure is called for.
iii) Equal Marginal Sacrifice Under this rule, the marginal sacrifice made by
low-income person (DC) should equal the marginal sacrifice of high-income
person (D
1
C
1
). It leaves both the individuals with the same after tax income.
For declining MU schedule, the equal marginal sacrifice rule would require a
progressive tax structure and is the best one for the low-income taxpayer. If
MU were constant the distribution would be indeterminate.
Mathematically,
Equal Absolute Sacrifice: U (Y) U (YT) i.e., the difference between utility out of
pre-tax income and out of post-tax income should be the same for all individuals.
Equal Proportional Sacrifice: [{U (Y) U (YT)} / U (Y)] i.e., the difference between
utility out of pre-tax income and out of post-tax income as a proportion of the pre-
tax utility should be the same across all individuals.
Equal Marginal Sacrifice: d U (Y T) / d (Y T) i.e., the rate of change in utility of
the individuals because of the tax should be the same for all.
Where, Y =Income, T =Tax Amount, U (Y) =Utility derived from income
11.5 PROPORTIONAL VS. PROGRESSIVE TAXES
A proportional income tax is one where each taxpayer pays the same proportion of
his income as taxes. Fig.11.3 shows the average and marginal tax rates under
proportional and progressive tax structure. In the figure, the X-axis represents income
i.e., the base of taxation and the Y-axis represents the tax rate. The heights of the
curves represent the rates. It can be seen that under proportional income tax, the
marginal tax rate is a constant and is equal to the average tax rate. In a progressive
tax structure, on the other hand, the proportion of income paid as tax goes up with
income. The marginal tax rate is higher for higher income levels as can be seen from
the figure. The average tax rate also rises.
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34
Fig. 11.3
Check Your Progress 2
1) Why is the Benefits Received Approach not applicable for direct taxes?
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2) What do you understand by the concepts Horizontal equity and Vertical
equity?
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11.6 TAXATION OF CAPITAL
Should income from capital (e.g., interest and dividends, capital gains, property
income) be taxed and if so at what rate has been a debatable issue in tax policy
matters. Corporations are separate legal entities and are subject to tax rates different
from personal income tax. Unlike Personal Income Taxes, which tend to be
progressive, corporate tax is generally a flat tax.
Since the ownership of corporations rests with individuals i.e., the shareholders,
their income accrues to them as dividend. Therefore if both corporate income tax
and dividend tax were levied, it would amount to double taxation. One way out of
Low Middle High
A B C D
Tax Rate
Marginal rate under
progressive tax
Average rate under
progressive tax
Average and marginal rate
under proportional tax
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35
this double taxation is to provide tax credits to the dividend recipients if the corporate
income tax has already been paid. Otherwise the firms would resort to reducing
dividend payments and increase their retained earnings for further investment. As a
result, the capital value of the firm would go up leading to increased share values.
The shareholders would therefore benefit from capital gains. In the presence of a
capital gains tax, the shareholders would have to pay tax whenever the shares are
sold.
Similar argument runs for other forms of property income say, interest income. Hence
taxing interest and dividends amounts to double taxation as tax was imposed on
income out of which investment was made in the first instance. It is also argued that
tax on capital income reduces the post-tax rate of return and thereby lowers the
incentive of the entrepreneurs to undertake risk. Since investment, the prime mover
behind growth of the economy, entails risk-taking, this has implications for growth.
Taxing capital distorts the optimal choice between saving and investment. This issue
also brings the debate on an appropriate choice of tax base to the fore. Since income
is equal to consumption plus saving, whether tax should be imposed only on
consumption or on income is a related issue which is still a matter of debate even in
the case of India.
The arguments whether capital income should be taxed centres around three main
concerns of tax policy equity, efficiency and administrative complexity. There are
three main issues with respect to equity. Income implies contribution to the society
and consumption is what people take out of the system. Based on this argument, it
is argued that consumption should be taxed rather than income. If inheritances and
bequests are ignored, taxing income is equivalent to taxing life-cycle income as saving
today reflects the taxpayers choice of how much to consume tomorrow. This is
matter of their preference pattern in response to the interest rate. If capital income is
taxed, the people who decide to consume more tomorrow suffer discrimination.
Since consumption to income ratio falls with the rise in income (as rich people save
more than the poor, which implies that rich people have a lower consumption to
income ratio), a consumption-based tax is argued to be regressive. To what extent
can tax on consumption be made progressive is a different matter as policy makers
have to make hard decisions and moreover, it would infuse additional distortions
into the economy. Those who do not favour capital taxation argue that avoiding it
would eliminate not only distortions arising out of a hybrid systemwhere both individual
and corporations are taxed but a tax systems complexity to a large extent.
11.7 LAFFER CURVE
If we keep on raising the tax rates, would tax revenue also go up commensurately?
According to the well-known Laffer Curve relation, named after the economist Arthur
Laffer who introduced it into policy discussion in the United States, tax revenue first
rises as the tax rate is increased but beyond a tax rate t
m
, tax revenue starts to
decrease. So, the relation between tax rate and tax revenue is an inverted U-shaped
curve. In Fig. 11.4, the X-axis represents tax rate in per cent and the Y-axis represents
the tax revenue. The height of the curve shows the tax revenue at different tax rates.
As can be seen from the figure, the tax revenue is zero when the tax rate is zero. Tax
revenue again becomes zero when the tax rate is 100 per cent because people
would not work if the government takes away all their incomes in the form of taxes.
The tax revenue is the maximum at rate t
m
. A tax rate more than t
m
is argued to be
excessive and to the detriment of both the taxpayer and the government. The reason
Economics of Taxation
36
behind this fall is the substitution in favour of non-taxable free time or leisure undertaken
by the taxpayers.
But the hypothesis is based on assumptions which are a bit unrealistic. It is assumed
that leisure is costless. If leisure were expensive, people would not be induced to go
for more leisure even when tax rates are raised. Laffer Curve hypothesis has been
influential and has been used by those who argue in favour of tax cuts. The underlying
assumption is that tax cuts encourage people to increase their work effort. For
instance, in Fig. 11.4, if the tax rate is t
1
, tax revenue can be increased by reducing
rates. But there is not much empirical support for this argument.
11.8 TAX EVASION
Since tax is a compulsory levy imposed by the government, a good tax structure
should ensure that economic agents actually comply with it. For designing such a tax
structure some idea about the behaviour of the taxpayers is required. Below we
discuss such a model.
11.8.1 Allingham-Sandmo Model
One of the basic models on tax evasion is the Allingham-Sandmo model. This model
starts with the assumption that economic agents are amoral and risk averse.
As you know, according to the expected utility theory, in the case of risky projects
the economic agents make their choice on the basis of the weighted sum of the utility
values of the outcomes. The probability of the outcome is used as the weight.
In this case, since tax evasion is a risky venture, the following expected utility function
is used:
Max E (U) =(1 p). U [Y
N
] +p. U [Y
C
]
i) Where, p is the probability of being caught,
ii) Y
N
is the disposable income if the agent is not caught, where Y
N
=Y t.x.Y,
with t as the tax rate and x as the income voluntarily reported by the agent, and
iii) Y
C
is the disposable income if the agent is caught, where Y
C
=Y t.x.Y (1+
)(1 x) t.Y, is the penalty rate on detected but undeclared income. If the
economic agent is caught, it would have to pay the tax on the income that was
concealed plus a penalty on the tax the agent was trying to evade.
In this situation, the economic agent would have incentive to evade taxes if
p (1+)(1 x)tY <t.Y i.e., tax due
The left hand side of the inequality shows the marginal cost to the economic agent if
it is caught while trying to evade taxes and the right hand side shows the tax liability
had the agent reported the actual income.
But the assumption that the probability p of detection by the tax authorities remains
a constant, irrespective of the extent of evasion is not tenable. Generally, given the
paucity of resources with the tax administration, especially in terms of manpower, it
focuses only on the large evaders. Therefore the probability of detection p increases
with the extent of evasion.
According to the model, the way to discourage evasion is to raise the probability of
being caught p by strict enforcement and to raise the penalty . But stricter
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monitoring and enforcement would require better administration, so a higher p
would also imply increase in cost of tax administration. It is more expensive than
raising the penalty . But, a higher rate of penalty could induce the tax evader to
bribe the administration so as to reduce his cost. So, a higher could actually breed
further corruption.
11.9 INDIAN TAX STRUCTURE
11.9.1 Tax-GDP Ratio of the Central Government
In Indias federal structure, the taxing powers are divided between the three levels
of the government Centre, States and Local Governments. According to the theory
of fiscal federalism sub-central units should refrain from the taxation of mobile units.
The basic principle underlying revenue assignment is that taxes on mobile factors
and those involving redistribution and stabilisation are best left to the central
government. Therefore, the major direct taxes are levied by the central government
and they are Personal Income Tax and Corporate Income Tax. The state and local
governments are generally assigned immobile tax bases. Though the states are
empowered to levy tax on agricultural incomes, this tax is yet to be exploited properly.
Property tax, which comes in the domain of the local governments, is a major source
of revenue for them.
Table 11.1 shows the tax-GDP ratio of the central government. As can be seen from
the table, bulk of the governments tax revenue comes from indirect taxes. Indirect
tax-GDP ratio rose continuously till 1990-91, thereafter it declined with the
introduction of fiscal reforms in 1991. The growth in direct tax-GDP ratio, on the
other hand, has not been impressive. Therefore, the overall tax-GDP ratio came
down. Of late it has begun inching upwards, even though it is much low by international
standards. The composition of tax revenue is shifting in favour of direct taxes. The
share of direct taxes increased from 14 per cent in 1990-91 to 24 per cent in
2003-04.
Table 11.1: Tax-GDP Ratio (Centre)
(per cent)
Year Direct Tax Indirect Tax Total
1950-51 1.77 2.31 4.08
1960-61 1.70 3.51 5.21
1970-71 1.90 5.12 7.02
1980-81 2.08 7.08 9.17
1990-91 1.94 8.19 10.12
1995-96 2.83 6.54 9.36
2000-01 3.27 5.76 9.03
2001-02 3.05 5.19 8.23
2002-03 3.38 5.38 8.76
2003-04 (RE) 3.75 5.49 9.23
2004-05 (BE) 4.49 5.73 10.22
Source: Ministry of Finance, Indian Public Finance Statistics 2004-05
11.9.2 Marginal Tax Rates and Exemption Limit
Marginal tax rate is the rate on the last unit of income earned. It is different from the
average tax rate, which is the share of total taxes in total income.
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38
Marginal Tax Rate = Tax Liability / Taxable Income
Average Tax Rate =Total Tax Liability / Total Income
Table 11.2 shows the exemption limit and the marginal tax rate for the highest income
bracket for Personal Income Tax in India for select years. The purpose of exemption
limit is to exclude the small income earners from the tax net. Income till this limit is
exempt from tax. It can be seen that the exemption limit has been raised continuously.
In real terms, however, the exemption limit in 2005-06 is slightly lower than the
exemption limit in 1965-66. The marginal tax rate for the highest income bracket
used to be very high. It was as high as 85 per cent in 1971-72. In conformity with
the trends worldwide, the marginal tax rate was progressively reduced and at present
it is 30 per cent. .
Another important concept relevant for income tax is standard deduction. This
provision allows the taxpayer to deduct a specified amount or a per cent of the
income in arriving at the taxable income so as to account for the incidental expenses
incurred in earning the income. This is in lieu of the itemized deduction of expenses
which would complicate the tax structure and create scope for false reporting. The
standard deduction now stands abolished in India for salaried taxpayers.
Table 11.2: Exemption Limit and Marginal Tax rate for the highest
income bracket for Personal Income Tax in India
Year Exemption Limit
(Rs.)
Marginal Tax rate for
the highest income
bracket (%)
1965-66 3000 65
1970-71 4000 75
1971-72 5000 85
1975-76 8000 70
1980-81 10000 60
1990-91 22000 50
1995-96 40000 40
2000-01 50000 30
2005-06 100000 30

Source: Constructed from Table A 1 in Das Gupta, A. 2005. Recent Individual
Income Tax Reform, Economic and Political Weekly, 2 April: 13971417.
11.9.3 Tax Reforms
Tax reforms constituted an important element of economic reforms introduced in
India. The focus has been on simplifying the structure and in bringing down the rates.
As we saw above, the marginal tax rate has been brought down drastically. This
was expected to curb evasion and improve revenue productivity. Of late, the efforts
seem to have yielded some success. As can be seen from Table 1, in recent years
there has been some improvement in Direct Tax-GDP ratio.
The government has from time to time appointed committees to look into problems
of Indian tax structure and suggest ways to improve the revenue productivity of
taxes in an efficient manner. The major recommendations of two of the major recent
committees with regards to direct taxes are given below:
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39
a) Chelliah Committee
In 1991, the Government of India appointed the Tax Reforms Committee under the
Chairmanship of well-known economist Raja Chelliah. The committee was in favour
of a moderately progressive tax structure, which when combined with strong
enforcement would improve compliance. The specific recommendations of the
committee regarding direct taxes were as follows:
To lower the rates of income taxation and to narrow the spread between the
rate in the lowest tax bracket and the maximum marginal rate.
Tax incentives should be kept at the minimum.
Taxation of income of partnership firms as well as that accruing to the partners
amounts to double taxation and should be avoided.
Corporate tax rate should be lowered to 40 per cent. The spread between the
tax rates applicable to foreign companies and that to domestic companies should
be around 7.5 per cent. In no case should it exceed 10 per cent.
For levying wealth tax, distinction should be made between productive assets
and non-productive assets and the former should be exempted.
b) Kelkar Task Force on Direct Taxes
In 2002, the Task Force on Direct Forces was appointed under the chairmanship of
Vijay Kelkar. The broad objectives of the Task Force, according to the report,
were a) to render quality taxpayer services to encourage voluntary compliance of
tax laws; and b) to detect and penalize non-compliance. As for the tax structure and
rates the Task Force used the following as the guiding principles:
i) The basic exemption limit should be at a moderate level
ii) The number of tax slabs should be few and in order to minimize distortions
arising due to bracket creep the range should be large
iii) The marginal rate for highest tax income bracket should be moderate so as to
reduce incentive for tax evasion and to lessen distortion creating behaviour of
taxpayers
The following are the major recommendations of the Task Force.
a) For Personal Income Tax
Increase in Exemption limit to Rs. 1 lakh for general taxpayers and Rs.
1.5 lakh for senior citizens and widows.
Introduction of tax structure with two rates 20 per cent upto an income
of Rs. 4 lakh and 30 per cent for income above Rs. 4 lakh.
Elimination of standard deduction and tax incentives.
b) For Corporate Income tax
Lowering of rate to 30 per cent for domestic companies and 35 per cent
for foreign companies.
Minimum Alternate Tax (MAT) tax was introduced in 1997-98 to bring
the Zero Tax Companies into the tax net. Zero Tax companies were making
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40
profits according to their profit and loss account and were declaring
dividends but when computed as per the provisions of the income tax act
their profit was insignificant, because of various deductions. The committee
was in favour of the elimination of MAT.
Long term capital gains to be subjected to normal taxation by merging
themwith other income.
Reduction in the rate of depreciation to 15 per cent.
c) Wealth tax should be abolished
d) The task force laid a lot of emphasis on improvement of tax administration. The
specific recommendations in this regard are:
Increased use of Permanent Account Number (PAN) by extending it to
all taxpayers.
The government should establish a national Tax Information Network (TIN)
which could be accessed by both tax administration and taxpayers. It
should use state-of-the-art IT infrastructure and should serve as repository
of information on tax payments and refunds.
11.9.4 Tax Evasion in India
As mentioned above, India has one of the lowest tax-GDP ratios in the world. One
major reason for the low revenue productivity of taxes in India is high degree of
evasion. It is argued that Indias complicated tax structure, ridden with a plethora of
exemptions and incentives and unprofessional tax administration, helps tax evasion.
In one of the recent studies on the black economy in India, Professor Arun Kumar
defines black incomes as factor incomes, property incomes, which should be reported
to the tax authorities but are not. The study estimates that, for the year 1995-96, the
black economy constituted about 40 per cent of GDP 32 per cent originated in the
legal sectors and 8 per cent in illegal activities. Much of it is concentrated in the
service sector as valuation of activities is difficult in this sector and it has a large
unorganized component. Contrary to popular perception it is argued that black
incomes are concentrated in the high-income categories, among individuals and
business class. Consumption and investment expenditures incurred out of black
incomes have implications for growth, fiscal health of the government and external
account balance. It lowers the quality of public services for two reasons first it
reduces the funds available for undertaking public expenditures and second siphoning
off of the available funds makes whatever expenditure made ineffective. Therefore
the existence of black economy leads to policy failure and overall reduction in welfare.
Check Your Progress 3
1) Keeping the Allingham-Sandmo model in mind, can you suggest some policy
measures for reducing tax evasion in India?
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41
2) What has been the importance of Direct taxes in the Central Government revenue
in India? Do you think reforms in direct taxes have yielded results?
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11.10 LET US SUM UP
We began this unit by discussing the basic principles which any tax structure is
supposed to confirm to. Two of these principles efficiency and equity have been
discussed in greater detail in the context of direct taxes. It was found that imposition
of a direct tax could distort the allocation of resources in the economy. Also the
guiding principles for an equitable direct tax structure were discussed.
We then moved on to the distinction between a proportional and progressive tax. In
the former the marginal tax rate and the average tax rate are equal and constant. In
a progressive tax structure both are rising.
This is followed by a discussion on the issues involved in taxation of capital. The
next section took up the well-known Laffer Curve Hypothesis.
In the following section, the issue of tax evasion was taken up. We discussed a
simple model, which set out the conditions under which taxpayers would have incentive
to evade taxes.
Finally, we turned to Indian tax structure and looked at the importance of direct
taxes in the central government revenue. It was seen that the thrust of tax reforms
has been on lowering the rates and simplifying the structure so as to improve
compliance. Of late, with a slight upturn in the direct tax-GDP ratio, tax reforms
seem to have yielded some positive result.
11.11 KEY WORDS
Optimal Tax System : It is a Pareto efficient tax structure which
maximises a given social welfare function.
Compliance Costs of Taxes : Costs incurred by the taxpayers in order to
comply with the tax obligations as per Tax
Laws over and above the costs arising out of
distortions.
Lump-Sum Taxes : It is generally called head tax when the taxable
amount is determined independent of the
taxpayers characteristics.
11.12 SOME USEFUL BOOKS
Hillman, A.L., 2003, Public Finance and Public Policy, Cambridge University
Press, U.K.
Economics of Taxation
42
Kumar, A., 1999, The Black Economy in India, Penguin, New Delhi.
Musgrave, R.A., 1959, The Theory of Public Finance, A Study in Public
Economy, McGraw-Hill Book Company, INC. and Kogakusha Company, Ltd.,
Tokyo.
Musgrave, R.A., and P. B. Musgrave, 1989, Public Finance in Theory and
Practice, McGraw-Hill Book Company, Singapore.
Stiglitz, J. E., 2000, The Economics of the Public Sector, W.W. Norton & Company
Inc., New York.
11.13 ANSWERS/HINTS TO CHECK YOUR
PROGRESS
Check Your Progress 1
1) See Section 11.2
2) See Section 11.3
Check Your Progress 2
1) See Sub-section 11.4.1. In the case of direct taxes there is no clear link between
the benefits received and the taxes paid.
2) See Sub-section 11.4.2
Check Your Progress 3
1) See Sub-sections 11.8.2 and 11.9.4. Focus on tax rates and administration
2) See Sub-sections 11.9.1, 11.9.2, 11.9.3
11.14 EXERCISES
1) Imposition of a direct tax does not change the relative price of commodities.
Then how does it distort the choice of the economic agent?
2) How does the Ability to Pay Approach help in the design of an equitable
direct tax structure?