To Spend in India, First Cut Taxes

High rates don't do any good if people don't pay.

Modi can't afford to look like he's embracing the rich.

Photographer: Vipin Kumar/Hindustan Times via Getty Images

Huge, probably unrealistic hopes are riding on Indian Prime Minister Narendra Modi's first full-year budget, expected on Feb. 28. Nine months after sweeping to office on a wave of hype and promises of bold economic reforms, Modi has yet to follow through with the kind of radical changes that many of his loudest cheerleaders believe are necessary to revitalize the economy. Doubts are setting in. The budget is Modi's chance to reverse them.

The reality, of course, is that no single budget can solve or even tackle the full range of problems that afflict India's sputtering economy. Several of the most important reforms -- for instance, to revamp laws dealing with labor and land acquisition -- will require standalone legislation that will face tough opposition in the upper house of Parliament. Still, the budget only needs the approval of the lower house, which Modi's Bharatiya Janata Party thoroughly dominates. That makes it doubly important to get the policies included in it right.

India's Aspirations

The most powerful reform Modi could introduce might also be one of the most popular: cutting taxes. This might sound counter-intuitive, given India's continuing fiscal pressures. But handled correctly, lowering overall tax rates should lead to a boost in revenue.

The government is facing renewed populist pressures. The BJP's crushing defeat in Delhi’s recent state elections -- to a left-leaning party that offered a variety of freebies to voters -- ended its string of impressive state-level performances since Modi's inauguration. The temptation will obviously be to minimize pain in the budget, perhaps even to expand wasteful subsidy programs.

Instead the government should slash income taxes. Currently, barely 3 percent of India's 1.25 billion people pay income tax. That figure is absurdly low even considering the hundreds of millions of poor who are exempt. Even the most pessimistic estimates suggest they account for no more than 30 percent of the population.

In the late 1970s, India's top tax rate exceeded 90 percent, and most wealthy Indians conducted as much of their business as possible off the books in order to evade the tax man. Unsurprisingly, by 1991 the country's direct tax-to-GDP ratio (which includes both corporate and income taxes) stood at a paltry 1.9 percent. With the onset of economic liberalization, tax rates were lowered, which helped encourage more middle-class Indians to pay up. The direct tax-to-GDP ratio has improved to 5.6 percent. Combined with a reduction of loopholes and more transparent collection efforts, lower taxes should buoy revenues over the medium term.

The last radical cut in corporate and income taxes took place 18 years ago, when the latter were divided into three "slabs": 10 percent, 20 percent and 30 percent. Since then, instead of reducing rates, the government has increased the number of people exempt from paying tax to those earning less than 300,000 rupees (roughly $5,000) per year. Surcharges have been added to the top rate in an attempt to boost revenues. The budget is Modi's chance to rework this structure, lowering the three tax rates to 5 percent, 15 percent and 25 percent, and ending all surcharges on the top rate. The government should also impose a moratorium on increasing the exemption limit, so that more Indians are drawn into the tax net.

This is not, on the other hand, an opportune moment to reduce corporate taxes, which are 34 percent for most companies. While that rate is comparable to France and Japan and lower than the U.S., it is much higher than some emerging economies like China, Malaysia and Indonesia (25 percent) or Russia (20 percent).  For India to be competitive, the rate needs to come down. However, Modi already has a reputation for favoring India's big industrialists, who were major contributors to his campaign. After the Delhi debacle, he can't afford to look like he's coddling the rich.

Leaving corporate rates where they are should also minimize any losses to the exchequer. In the meantime, the government could move to simplify the needlessly complex corporate tax structure. Eliminating surcharges would bring the rate down to 30 percent. The government could also begin to lift sector-specific exemptions which have encouraged rent-seeking and tax evasion. This would set the stage for a reduction in the corporate tax rate to 25 percent, or even 20 percent, over the next four years.  

A more transparent direct tax system with moderate rates and no exemptions would greatly boost India’s competitiveness, as well as GDP. It would be unrealistic to accomplish all of this in a single budget, of course. But Modi would be wise to get started on the task.

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