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1. INTRODUCTION
1.1

Taxation in India A Contextual Outline

A tax (from the Latin taxo) is a financial charge or other levy imposed upon a
taxpayer (an individual or legal entity) by a state or the functional equivalent of a
state to fund various public expenditures.1
A tax is a pecuniary burden laid upon individuals or property owners, particularly
contributed to government, and it is a payment exacted by legislative authority. It is
not a voluntary payment or donation, but an enforced contribution to support the
government. Taxes consist of direct or indirect taxes and may be paid in money or
as its labour equivalent (often but not always unpaid labour).
Direct tax, in a general sense, is imposed upon an individual person (juristic or
natural) or property (i.e. real and personal property, livestock, crops, wages, etc.).
A direct tax is one that cannot be shifted by the taxpayer to someone else. Income
tax, corporation tax, estate tax, property tax are a few example of direct taxes.
Indirect tax (such as sales tax, per unit tax, value added tax (VAT), or goods and
services tax (GST)), on the other hand, is a tax collected by an intermediary (such
as a retail store) from the person who bears the ultimate economic burden of the tax
(such as the consumer). The intermediary later files a tax return and forwards the
tax proceeds to government with the return. In this sense, the term indirect tax is
contrasted with a direct tax, which is collected directly by government from the
persons (legal or natural) on whom it is imposed.
India has a well developed taxation structure. The tax system in India is mainly a
three tier system which is based between the Central, State Governments and the
local government organizations. In most cases, these local bodies include the local
councils and the municipalities. According to the Constitution of India, the
government has the right to levy taxes on individuals and organizations. However,
the constitution states that no one has the right to levy or charge taxes except the
authority of law. Whatever tax is being charged has to be backed by the law passed
by the legislature or the parliament. Article 246 (SEVENTH SCHEDULE) of the

1 Charles E. McLure, Jr. Taxation. Britannica.

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Indian Constitution, distributes legislative powers including taxation, between the

Parliament and the State Legislature.
In the Indian economy, the taxation has not contributed a lot to the national income
mainly due to distribution effect of the national income. For raising the
contribution of taxation, it becomes essential that investment decisions are liberal
to the development of large-scale industries. The non-optimal relationship between
the direct and indirect taxes has also affected the contribution of taxation to the
generation of national income. It is found that direct taxes contribute only 15 per
cent of the total tax revenue.2 For raising the instrumentality of taxation, it is
essential that the contribution of direct taxes is raised to a considerable extent.
In 2015-2016, the gross tax collection of the Centre amounted to 14.60
trillion (US$220 billion)3.

1.2

Objectives
Set in the above perspective or background, the broad objective of the study is to:

1. To study importance of tax in Indian economy.

2 S. M. Jha, Taxation and the Indian Economy.

3 Taxation in India, Wikipedia, (6 August 2016), https://en.wikipedia.org/wiki/Taxation_in_India

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2. To study tax and its effect on economic growth of India and to analyse its impact on
GDP.

1.3

Hypothesis
Indirect tax is a major contributor to the developing economy of India and is
beneficial to the economy with changing times.

1.4

Literature Review
1) Taxation and Economic Growth Gareth D. Myles
This article gives a theoretical perspective through which the effects of
taxation on economic growth can be explored. It shows many theoretical
models that isolate a number of channels through which taxation can affect
growth and this growth can be very substantial.
2) Indirect Tax Reforms in the Indian Economy T.R. Rustagi
This paper highlights the importance of indirect taxes, through its evolution
and its impact in current times. It records the progress done by the country with
the changing times since independence and suggests the scope of improvement
that still needs to be done for further development of the Indian economy.
3) Thirty years of Tax Reform in India Shankar Acharya
This paper highlights the contours of India's tax reform story from the mid1970s to the present and presents the enormous progress that has been made in
the last 30 years, judged by the standards of economic efficiency, equity, builtin revenue elasticity and transparency.

1.5

Scope of the study

The present project is an attempt to analyze taxation, specifically indirect and
direct tax and its effect on the Indian economy and conclude the study thusly.

1.6

Methodology of the study

This project is based on a non-doctrinal research methodology. Relevant points
along with some examples have been provided to prove some points in the topic.

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Accumulation of the information on the topic includes various secondary sources

such as books, articles, e-articles, etc. The matter from these sources has been
complied and analysed to understand the topic in a better way.

2.

CHANGING SCENARIO AND TAX REFORMS

Tax systems the world over have undergone significant changes during the last

twenty years as many countries across the ideological spectrum and with varying
levels of development have undertaken reforms. The wave of tax reforms that began in
the mid-1980s and accelerated in the 1990s, was motivated by a number of factors. In
many developing countries, pressing fiscal imbalance was the driving force. Tax policy
was employed as a major instrument to correct severe budgetary pressures. In others,
the transition from a planned economy to a market economy necessitated wide ranging
tax reforms. Besides efficiency considerations, these tax reforms had to address the
issues of replacing public enterprise profits with taxes as a principal source of revenue
and of aligning tax policy to change in the development strategy.
Another motivation was the internationalization of economic activities arising from
increasing globalization. On the one hand, globalization entailed significant reduction
in tariffs, and replacements had to be found for this important and relatively easily

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administered revenue source. On the other, globalization emphasized the need to

minimize both efficiency and compliance costs of the tax system.
Unlike most developing countries, which were guided in their tax reforms by
multilateral agencies such as the International Monetary Fund, Indian tax reforms have
largely borne a domestic brand. Thus, even when the government sought assistance
from multilateral financial institutions, the recommendations of these institutions did
not directly translate into an agenda for tax reform. Despite this, the tax system
reforms were broadly in conformity with international trends and advice proffered by
expert groups and was in tune with international best practices. Inevitably tax policy in
the country has responded to changing development strategy over the years and to the
changing global scenario. Some of the changes during past few years include reduction
in excise duties in post global financial & economic crisis, alignment of custom tariffs
to the levels prevailing in ASEAN countries, introduction of Service tax in 1994-95
besides introduction of the Constitution(115th Amendment) Bill in the Lok Sabha in
March 2011 to operationalize Goods & Services Tax(GST).
In India, the authority to levy taxes is divided between the Union government and the
State Governments under the relevant Acts. The Union Government levies direct taxes
such as personal income tax and corporate tax, and indirect taxes like custom duties,
excise duties and central sales tax. The States are empowered to levy State sales tax
and other local taxes like entry tax, etc.

3. ROLE OF TAX IN INDIAN ECONOMY

Tax is a contribution exacted by the state. It is a non-penal but compulsory and

unrequited transfer of resources from the private to the public sector, levied on the basis
of predetermined criteria.
The classical economic were in view that the only objective of taxation was to raise
government revenue. But with the changes in circumstances and beliefs, the aim of
taxes has also been changed. These days apart from the object of raising the public
revenue, taxes is levied to affect consumption, production and distribution with a view
to ensuring the social welfare through the economic development of a country. Fiscal
policy or budget has become important instrument in promoting growth and

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development in such economies. Taxation is an important part of fiscal policy which

can be used effectively by governments of developing economies.

3.1

Role of Direct and Indirect Taxes

The role of taxation in developing economies can be explained as:
1. Resource Mobilisation
Taxation enables the government to mobilise a substantial amount of revenue.
The tax revenue is generated by imposing: Direct Taxes such as personal income
tax, corporate tax, etc., Indirect Taxes such as customs duty, excise duty, etc.
In 2006-07, it is estimated that the tax revenue of the central government (India)
was 81% of the total revenue receipts, whereas, non tax revenue was only 19%4.
2. Reduction in Inequalities of Income
Taxation follows the principle of equity. The direct taxes are progressive in nature.
Also certain indirect taxes, such as taxes on luxury goods are also progressive in
nature. This means the rich class has to bear the higher incidence of taxes, whereas,
the lower income group is either exempted from tax (direct taxes) or has to pay
lower rate of duty (indirect taxes) on goods consumed by the masses. Thus,
taxation helps to reduce inequalities of income and wealth.
3. Social Welfare
Taxation generates social welfare. The social welfare is generated due to certain
undesirable products like alcoholic products, tobacco products and such other
products are heavily taxed, which restricts their consumption, which in turn
facilitates social welfare.
A part of the tax revenue is utilised for social development activities, such as
health, education and family welfare, which also improve social welfare as well as
social order in the society.

4 Gaurav Akrani, Role of Taxation in Developing Countries like India, Blogspot, (30 Dec. 2010), http://kalyancity.blogspot.in/2010/12/role-of-taxation-in-developing.html

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4. Foreign exchange
Taxation encourages exports and restricts imports. Generally, developing countries
and even the developed countries do not impose taxes on export items. For
instance, in India, exports are exempted from excise duty, VAT, customs duty and
other duties. However, there is customs duty on imported goods. Therefore,
taxation helps to earn foreign exchange through the promotion of exports.
5. Regional Development
Taxation plays an important role in regional development; Tax incentives such as
tax holiday for setting up industries in backward regions, which induces business
firms to set up industries in such regions, Tax revenue collected by government is
also utilised for development of infrastructure in backward regions.
6. Control of Inflation
Taxation can be used as a tool of controlling inflation. Through taxation, the
Government can control inflation as follows
If inflation is due to high rise in prices of essential items, then the Government may
reduce the rate of indirect taxes. If inflation is due to increase in demand, the
Government may try to cut down the effective demand by increasing the tax rate.
Increase in tax rate may restrict consumption, which may reduce demand, and
subsequently inflation may be controlled.

4. CONTRIBUTION OF TAXATION IN INDIAN ECONOMY

India is believed to have lower tax GDP ratio. As per World Bank Database (Taxes
collected by Central Government) the 10.7 % ratio in case of India , during 2012, is
less than the world average of 14.4 % and much lower than 19.4 % ratio in case of
European Union, which has traditionally higher levels of Tax GDP Ratio.
Neighbouring economies like Bangladesh & Pakistan also have ratio at around 10%.
Some argue that higher tax GDP ratio translates into better infrastructure etc by taxing
the rich through direct taxes but in the globalised world, things have become
increasingly complex as lower taxes might attract more business.

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Overall tax ratio (including State taxes, social security contributions etc.) is also
widely used by many, including OECD countries. As per the data compiled by them,
the average tax to GDP ratio in OECD countries was 34.6 per cent in 2012 compared
with 34.1 per cent in 2011 and 33.8 per cent in 2010. In US (24%) & Japan (28%) on
the other hand, continue to have the ratio below 30 % .The Recent recovery of OECD
countries is still below the most recent peak year of 2007 when tax revenues to GDP
ratios averaged 35.0 per cent. In India too, even though the tax GDP ratio increased
marginally during 2008-09 and 2009-10 , the annual growth rate (about 2-3 %) was far
below the period immediately preceding and succeeding these years when the growth
was more than a quarter (i.e. above 25%). As per Indian Public Finance Statistics
2012- 13, Ministry of Finance, including States share also, Indias tax GDP ratio was
expected to be around 17.2% reaching to about the same level as before financial crisis
in 2008.
As one moves up the income ladder, the ratio is expected to climb because it is nonsubsistence income that are taxed. But much wealthier countries in the region like
Malaysia & Thailand also do not have significantly higher tax GDP ratio (Central Govt
taxes: 2012) with the values at 16.1 & 16.5 % respectively , even though their higher
per capita income puts them in an advantageous position to bear higher tax burden.
Even China, which has about three times per capita income compared to India, has tax
GDP ratio at levels identical to that of India. Hence the level of taxation in case of
India seems in consonance with the prevalence elsewhere in Asia. However
introduction of comprehensive goods & services tax (GST) and plugging the tax
evasion might increase the revenues further.

Some postulate that an economys tax-to-GDP ratio is, or should be, a function of its
per capita GDP, and hence it is misleading to compare Indias with those much
wealthier. The theoretical basis for such an assertion is debatable, and empirical
evidence for this is also lacking. While Indias own tax-to-GDP has increased over
50 years with increasing per capita GDP, superficially supporting the theory, this
fact hides more than it reveals, if one breaks the time period of study into two
quarter-century periods. In the 25-year period from 1965 to 1990, Indias tax-toGDP increased steadily from 10% to 16% while GDP increased 2.8-fold. In the
subsequent 25-year period from 1991 to 2014, Indias tax-to-GDP stayed roughly

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constant between 16% and 17% while GDP increased 4.5-fold 5. It is puzzling to us
that just as India broke away from its clichd Hindu rate of growth post the 1991
economic reforms to grow much more rapidly, its tax-to-GDP ratio stayed constant,
belying those who would have predicted an increase. That, curiously, Indias rate of
tax revenues did not grow commensurate with its GDP growth post the 1991
reforms are inexplicable.
The second and perhaps the more important deviation in Indias tax structure from
other major economies is in terms of the split of the total tax take between direct
and indirect taxes. Direct taxes are taxes on income, wealth, property and capital
gains. Indirect taxes are taxes on goods, services and excise taxes. Indirect taxes are
considered regressive since its marginal impact on the economically weaker
sections of society is far greater. Indias direct to indirect tax ratio is roughly 35:65.
This is in contrast to most OECD economies where the ratio is the exact opposite,
67:33 in favour of direct taxes. In the 50-year period analysis, Indias direct-toindirect tax ratio has swung from a low of 13:87 to its current high of 35:65. For the
OECD nations, throughout this 50-year period, the direct-to-indirect tax ratio has
remained roughly constant in the range of 65:35.
Although it is widely accepted that indirect taxes have become an important source
of development funds in developing countries. Many developing economies that
have adopted economic planning use indirect taxes as important source of funds.
These taxes are found to be better suited in developing countries because they have
much wider coverage as compared to direct taxes. Both rich and poor pay indirect
taxes in form of commodity price.
High rate of taxes on luxury goods will take away resources from the rich and such
resources re-distributed among the poor in the form of subsidies besides taxes on
product like alcohol, cigarettes can have beneficial effect on consumption pattern.
Indirect taxes are used to divert resources from less desired use to more desired one
in developing countries. Taxes on goods considered to be luxuries will make them
5 Praveen Chakravarthy, India is an outlier in its tax policy, Livemint (22 February 2016),
http://www.livemint.com/Opinion/brbD6Tw1akpGS3um0t3CaM/India-is-an-outlier-in-its-tax-policy.html

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more expensive, lower their demand and profitability. This will divert their
resources from the production of these goods to more essential ones. Taxes on
imported goods have been used by developing countries for reducing imports and
promoting domestic industries.
On other hand in developing economies collection of direct taxes is believed to be
very significant. Only a small proportion of population pays such taxes. Direct taxes
are primary used in such economies to reduce inequalities of income distribution.
High degree of progression is used in case of direct taxes in developing countries.
This discourages savings done by high income group and adversely effects
investment and capital formation. Highly progressive taxation leads to tax evasion
and black money.
Thus direct taxes have been postulated to have a limited role to play in developing
countries and indirect taxes have become an important source of development funds
in developing countries. But still, the question arises, that whether there should be a
desirable balance between direct and indirect tax contribution.
Economic literature lays down two principal views. The first view, which was
popular in the 19th century and into the middle of the 20th century, is the desirable
balance view roughly, the idea that there should be something like a half-andhalf split. The great 19th century liberal prime minister of Great Britain, William
Gladstone, subscribed to this view, for instance, suggesting that direct and indirect
taxes were akin to two attractive sisters each with an ample fortune. Eventually,
however, with the advent of mathematical optimization techniques in economics,
the consensus view shifted to what is now the mainstream view, what economist
Anthony Atkinson calls superiority of direct taxes.
According to the modern view, direct taxessuch as income or wealth taxes
function better both in terms of efficiency and equity, while indirect taxes are
inferior. What is more, ideologically, both left and right should prefer direct taxes to
indirect taxes, for different reasonsthe left for reasons of progressivity, the right
for reasons of minimizing inefficiency. If indirect taxes must be used, perhaps
because of some constitutional or political economy constraint on the level of

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income or wealth taxes that a government may levy, then ideally they should be
minimally distortingin effect, by mimicking the effects of a direct tax.
An example of a good indirect tax is a single rate goods and services tax (GST)
with no exemptions. Such a tax distorts individuals labour supply and savings
choices, like direct income and wealth taxes, but does not distort the economys
structure of production or consumption, as most indirect taxes, such as trade tariffs,
do. The worst taxes are sector-specific excise taxes with high tax ratessuch as
taxes on petroleum, alcohol and tobaccowhich are maximally distorting to the
economy and maximally regressive. They are also among the most popular for
governments the world over, because they are good ways to grab a lot of revenue,
although not good for the economy or its citizens.

5.CONCLUSION

Both direct and indirect taxes are essential to bring adequate revenue to the state
for meeting the increasing public expenditure. Both taxes are essential to promote
economic growth, fill employment and economic stability. Direct and indirect taxes
should side by side & balance each other. It is debatable as to which carries more
importance or is there a need of more than a desirable balance and a significant
importance to one than the other in a developing country like India. Thus, both are
an important contribution to the prosperity of the Indian economy which is still
developing and with changing times and tax reforms, the economy will flourish.

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5. BIBLIOGRAPHY
Articles
Gareth D. Myles, Taxation and Economic Growth, Fiscal Studies (2000) vol. 21, no. 1,
pp. 141168
T.R. Rustagi, Indirect Tax Reforms in the Indian Economy, Vol. 23, No. 1, January March 1998
Shankar Acharya, Thirty Years of Tax Reform in India, Economic and Political
Weekly, Vol. 40, No. 20 (May 14-20, 2005), pp. 2061, 2063- 2070
Websites
Taxation in India, Wikipedia, (6 August 2016),
https://en.wikipedia.org/wiki/Taxation_in_India
Gaurav Akrani, Role of Taxation in Developing Countries like India, Blogspot, (30
Dec. 2010), http://kalyan-city.blogspot.in/2010/12/role-of-taxation-in-developing.html
Praveen Chakravarthy, India is an outlier in its tax policy, Livemint, (22 February
2016),

http://www.livemint.com/Opinion/brbD6Tw1akpGS3um0t3CaM/India-is-an-

outlier-in-its-tax-policy.html