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The public interest in subsidies and tax exemptions

Why is cutting subsidies seen as the only way to cut down the government’s fiscal deficit, asks Kannan Kasturi. What about raising additional revenues by increasing direct taxation of the rich, reducing corporate subsidies and increasing customs duty on items such as gold?

taxing the poor

The word ‘subsidy’ gets the hackles of free market economists up. The government’s economic managers and advisors have consistently been in favour of eliminating – or at least reducing -- subsidies.

The present environment supports their argument. The economic slowdown has meant slower revenue growth and a larger than expected ‘fiscal deficit’ – the gap between the government’s income and expenditure – with pressure mounting to reign in the deficit. Numerous voices – from corporate chambers, financial media personalities, and even fund managers – have been calling on the government to reduce deficit by cutting down subsidies. With food inflation abating, the government strategy appears to be to utilise the period until March to build public acceptance of the elimination of subsidies and then make its moves after the state elections are out of the way.

The subsidies that the government wishes to cut or eliminate fund diverse programmes, with the common theme being that they make available some item of mass consumption – foodgrains, fuel or fertilisers – at prices controlled by the government rather than left to market forces.

The most elaborate subsidy is the food security programme with a Public Distribution System (PDS) that procures grain from farmers, maintains a buffer stock in storage, and makes the grain available around the year to 65 million households across the country through nearly half-a-million retail outlets. The oil programme has several components -- providing kerosene (used mainly for lighting by poor families) through PDS outlets; distributing Liquefied Petroleum Gas (LPG) for cooking to 115 million customers; and finally making diesel – 75% of which is used for mass transport, both rail and road, for agricultural machinery and for emergency power generation – available at government set prices. The last programme pays fertiliser manufacturers and importers to sell fertilisers to farmers at government set prices.

Government support for these programmes has the effect of lowering the expenditure of poor households. This assumes importance in the absence of a state-supported guarantee of minimum income levels. Social security – a fallback in case of unemployment, old age and incapacitation or illness – is non-existent for most Indians. A recent report (Divided We Stand: Why Inequality Keeps Rising) from the Organisation of Economic Co-operation and Development (OECD) finds India’s public social spending measured as a fraction of its GDP not only far lower than the developed countries, but also lower than China, Russia, Brazil, and South Africa, the ‘emerging economies’ with which it is often compared.   

Yet the government’s economic advisors choose to question the provision of subsidies.

The subsidies are criticised on several grounds. One is that they have unintended beneficiaries: people who can afford to pay higher prices. Why should the government subsidise diesel for cars and LPG cylinders for cooking for the rich, goes the argument. A second is that artificially low pricing encourages ‘leakages’ and improper use; PDS grain and kerosene meant for ration cardholders is sold for profit in the open market, the latter being used to adulterate the more expensive diesel. A third argument is that the government maintaining a low price for an oil product such as diesel hinders the efficient use of this costly resource and the development of cheaper alternatives.

All the above criticisms about these programmes are true but there are obvious steps that the government could take to make improvements. For instance, the government could easily tax cars with diesel engines to recover the cost of their using subsidised diesel. It could find ways to deliver the benefits of fertiliser subsidies directly to the farmer instead of passing these to fertiliser manufacturers and importers.  However, the actions contemplated by the government are not in the direction of improving the design and management of these programs. The driving concern is to reduce government expenditure.

The immediate target after the state elections in March appears to be to cut or eliminate government support for diesel and fertiliser pricing. Kaushik Basu, the Chief Economic Advisor to the government, has gone on record that “useless” subsides must be replaced by “infrastructure spending”. The stock prices of fertiliser companies have already gone up anticipating the increased profits they will make once fertiliser prices are decontrolled. Increase in fertiliser prices will squeeze the farmer and make food costlier and increase in diesel prices will make transport costlier and fuel inflation. The government would have saved money by pushing the burden of increased prices on the people at large; however, it is the poorest households who will be most affected.

Why is cutting subsidies seen as the only way to cut down the government’s fiscal deficit? Since fiscal deficit arises from the imbalance of revenue and expenditure, what about the possibility of raising additional revenue?

Taxes: How does India compare?

The Indian state derives an overwhelming part of its revenue – over 84% -- from taxes. Is India already a highly taxed nation? It is possible to obtain some perspective by comparing with other countries. Rather than the absolute numbers, a good measure for comparison is the fraction of the GDP that a country is able to mobilise in taxes.

Country

Tax/GDP (%)

Russia 37.0
Brazil 33.6
Argentina 30.7
South Africa 29.8
China 20.7
India 17.3

Total taxes as a percentage of GDP for select countries in 2008 (from the OECD)

The table above obtained from the OECD report referred to earlier, compares India with other ‘emerging economies’. India is at the bottom in this grouping. Tax collections in the developed economies of Europe range between 30% and 50% of GDP. Low as it was in 2008 the tax to GDP ratio in India has actually fallen further over the last few years and stands at 14.7% in 2010-11.

A closer examination of India’s tax collections provides more insights. They are skewed in favor of indirect taxes, with direct taxes constituting only 37% of the total collections. The bulk of direct taxes are taxes on the income of individuals (above a threshold) and the profits of businesses. Direct taxes, if properly administered, will target the rich as they will have higher incomes and own businesses. Indirect taxes, on the other hand, tax consumption and apply equally to every consumer, rich or poor.  

In 2009-10, there were only an estimated 30 million individuals, 400,000 non-corporate businesses, and about 4.7 lakh corporate businesses (companies), constituting the direct tax base. Less than 30,000 companies reported profits greater than Rs 1 crore each and these companies accounted for 95% of all corporate income tax collections. India’s direct tax base is extremely low.

A Comptroller and Auditor General (CAG) audit report (No 26 of 2010-11) indicates the possibility of a much larger tax base. Over 95 million Permanent Account Number (PAN) cards – mandatory for many financial transactions -- have been issued until the end of 2009-10, yet only 30 million individual tax returns were filed. As another statistic, there were 8.4 lakh registered working companies, but only around half this number were filing tax returns. There is indeed scope to raise more revenue by increasing the tax base and this is not a new idea. Yet these issues do not seem to occupy the mindspace of government’s economic advisors.

Some will argue that increasing the base of taxpayers is a long-term issue and may not provide immediate results. However, more difficult to explain is why the government’s economists are silent about the revenues that are being forgone in both direct and indirect taxes.

Handing out subsidies to corporations

In government parlance, revenue is considered forgone when the government provides tax concessions in the form of exemptions or special rates to preferred taxpayers. The concessions are justified as a policy choice of the government. These forgone revenues or ‘tax expenditures’ are also a form of subsidy, for a company or a specific industry.

Consider direct taxes. In 2009-10, companies paid tax at an effective tax rate of 23.53% on their profits, though the statutory tax rate was 33.99%, the difference accounting for the revenue forgone – over Rs 70,000 crore – on corporate income tax. Tax concessions were given, among others, on profits from exports, by allowing accelerated depreciation for capital assets, and on profits of companies in power, telecom, and infrastructure development. The average effective tax on income of companies in the sectors of software, information technology enabled services, property development, leasing, power and energy and drugs and pharmaceuticals was between 15-20%.

Interestingly, the 216 most profitable companies of India, each making above Rs 500 crore in profit, and accounting for over half of the corporate income tax collected, paid taxes at an effective rate of 22.5% while over 200,000 small companies with profits below Rs 1 crore paid taxes at the effective rate of 25.7%. The largest companies were in the best position to make use of the tax concessions offered by the government!

 

Tax collected ( Rs crore)

Revenue Forgone (Rs Crore)

Corporate income tax 244725 72881
Excise 102858 169121
Customs 85847 195288

Tax collection and revenue forgone in 2009-10 (Union budget papers, 2010-11)

The table above shows the revenues forgone in respect of various taxes in 2009-10. The projections for 2010-11 are on similar lines. The massive revenue forgone in indirect taxes such as customs and excise is far greater than the sum of the subsidies provided on food, fuel, and fertilisers.

Excise and Customs tax rates are defined in the schedules of the Central Excise Tariff Act, the Customs Act or in various Finance Acts. The government can however notify lower rates for any specific item in the ‘public interest’. The revenue forgone is the difference between the revenue actually collected and that, which could have been realised by levying the rates prescribed in the relevant Act. 

It is not the case being made here that low customs and excise duties are uniformly bad. Taxes on the consumption of certain goods can bite the poor as well as the rich. Petroleum products are an example. They are already heavily taxed, accounting for over one-third of the overall (central and state) indirect taxes. A measure such as removing customs duty on crude oil can therefore be justified.

However, consider another commodity, gold. India is the largest consumer and importer of gold in the world, using up much precious foreign exchange. While the Customs Act prescribes duty at 10%, the government notified duties of less than 1%, which were in force until mid-January 2012 when it raised it to 2%. India imported 963 tonnes of gold in 2010 valued at over Rs 1.7 lakh crore, and accounting for nearly 11% of India’s imports. The government collected a paltry Rs 2,836 crore as customs duty instead of a potential Rs 17,000 crore. What can be the ‘public interest’ in keeping the customs duty on gold low and forgoing this revenue?

Clearly, there are many options to reduce the fiscal deficit instead of doing away with the “useless” subsidies. The question is – why are the government’s economists fixated with the option that will make the poorest pay?

(Kannan Kasturi is an independent researcher and writes on law, policy and governance)

Infochange News & Features, January 2012