Income Taxt Reform I: A Benchmark Flat tax cum Transfer System

with Surjit S. Bhalla

 In his December 31^st speech, Prime Minister Modi made a pointed reference to the fact that in 2013-14, as per official Ministry of Finance data, there were only 2.4 million individuals declaring incomes above Rs. 10 lacs. As many have pointed out, no matter what the indicator used (number of big houses, luxury cars, yachts, private planes etc.) this is too small a number for an economy the size, and richness, of India. What this means is that there is a considerable amount of tax evasion– a rough estimate of the order of magnitude is around Rs. 6 to Rs. 9 lakh crores. Maybe a strange coincidence but this number corresponds closely to our estimates of black cash in the Indian economy in 2016-17, or as of November 8^th, 2016.

The battle against black income has been an ongoing one. It was included in the manifesto of the BJP government and has been on the agenda since it came to power in May 2014. Besides the Government and its supporters, opposition parties in Parliament have demanded that black money held abroad be identified and brought back. Even the Supreme Court came into the picture with the setting up of a Special Investigation Team (SIT) on black money under its oversight/supervision. A number of acts have been passed by parliament to tighten the screws and to make it more difficult to hold undeclared assets. And then there was demonetization on November 8^th.

As the history of the License Permit Quota Raj shows, that unless the economic incentive favor voluntary tax compliance and less political, bureaucratic and police corruption, any benefits are soon frittered away and negative effects multiply over time.  Consequently institutional reforms for minimizing corruption and policy reforms for encouraging voluntary compliance are very important. Something we outline below.

In the US, the IRS has been conducting an annual exercise since 2006, an exercise which attempts to identify the tax losses which arise from income tax evasion. For personal income tax (PIT), the concern of this article, the IRS estimates that of every $100 the US government does collect, about $ 20 is missed. One of the authors (Surjit) had conducted a detailed exercise on tax compliance in India in 2002; this report was conducted for the Ministry of Finance under the supervision of Mr. Vijay Kelkar (Task Force on Direct and Indirect Taxes). The report found that income tax compliance in India, while varying across income groups, was in the broad range of 10 to 30 %. 

Updating the method to the 2013-14 data (the same as used by PM Modi), we find that there should be approximately 10 million taxpayers earning above Rs. 10 lacs i.e. the compliance rate is only 25 %. For all taxpayers, and an estimate comparable to the IRS, we obtain the result that for every Rs. 100 obtained in PIT in India, Rs. 300 goes missing; on a very conservative basis, Rs. 200 goes missing. Whether this is the largest in the world, we do not know – but it has to be close to the top (one area where India is tops!).

This also puts into perspective PM Modi’s anti-black money (or black income) drive. We have consistently argued that the largest low hanging fruit in the Indian economy is the level of tax compliance.  And that one of the goals of demonetization has to be a change in the tax regime, a change that brings out an increase in tax compliance. 

The Union Budget for 2017-18 will be presented on February 1^st. We believe that de-monetization has provided the government with the courage, and the vision, of a major reform in direct income taxes. As shown below, one version of this reform is a move to a flat income tax rate of 12 %. Yes, that is the rate the average taxpayer actually paid in 2013-14! 

But what about progressivity in the tax system? Shouldn’t the rich be taxed more? We strongly believe that questions of ethics, and philosophy, and false morality should be kept out of the taxation system. Indeed, those who argue for higher tax rates are often those who have a vested interest in keeping tax rates high in order that their own personal (black) incomes increase – if you think we are hinting at the Income Tax Authority, you are right.

This Budget should be, and we hope will be, about reform of direct taxes. In previous budgets government has proposed reforms of the Corporate Income  Tax (CIT). These reforms are in the right direction, but have been carried out too slowly and must be accelerated.  The government is on track to introduce the  GST by August 2017, given that the Constitutional Amendment has been passed – we hope administrative matters will soon be sorted out.  Less attention has been focused on reform of the personal income tax and import-export tariffs and duties. 

We do believe that the rich, the well-off, should pay more in tax. Hence, this proposal focuses on reform of the personal income tax and the related issue of Direct Cash Transfers (DCT)/Net Income Transfers or Negative Income Tax (NIT). Note that an NIT policy was first outlined by Milton Friedman in the late 1950s.   

The Table  summarizes the important parameters of income tax compliance and revenue collection based on detailed Ministry of Finance data for 2013-14 (available at www.incometaxindia.gov.in) and uses these data to make projections for 2016-17. We want to be as close to revenue neutral as possible, and also provide for NIT. 

Some basic facts about income tax in India. In 2016-17, it is estimated that  sixty-two percent of the non-cultivator workforce in India earns below Rs. 2.5 lakhs a year. That is 205 million earners.  Our design of NIT is such that each worker earning below Rs. 2.5 lakhs will obtain some income transfer. A person with no income will receive Rs. 30,000 and one who earns Rs. 2.5 lakhs, will receive zero income transfer. The bill for NIT, for 2016-17, is estimated to be Rs. 2.92 lakh crores. Where will this money come from ?

From a minimum increase in tax compliance, which presently stands at 25 %. The flat tax rate we propose is 12 %, the rate actually observed in 2013-14, and very likely the tax rate estimated by the Ministry of Finance in making its revenue projections for 2016-17! [Note that this average rate includes surcharge and cess]. 

A flat tax rate of 12 %, even for a tax shy Indian, should be very appealing. We estimate that the compliance rate will increase by 8 percentage points to 33 percent. This increase in compliance will compensate for the extra revenue needed for the NIT proposal – i.e. 2.9 lakh crores. Incidentally, the tax revenue data for post demonetization November and December does suggest that an increase in tax compliance is taking place.

So will the Union Budget transform India into a moderately tax compliant economy? The Union Budget provides an opportunity for the Modi government to unleash a Big Bang reform in personal income taxation. The economy provides scope, and the demonetization the rationale, for a  flat income tax rate  and a negative income tax for the poor and the needy. Let not the de-monetization pain be in vain.

Table: Direct Taxes in India and Proposed NIT structure
	2013-14	2016-17#
Actual Revenue Data
Revenue (Total) (in lakh crore)	1.89	3.4
No. of Tax Payers (in millions)	22.8	31.5
Average Tax (in lakh crore)	82900	108000
Average Income of Tax Payers (in rupees)	693000	900000
Implicit Rate of Taxation (in per cent)	12	12*
Non Cultivator workers in economy, with incomes>2.5 lakhs (in million)**	91	126
Personal Income Tax Compliance Numbers (in per cent)	25	25
Proposed Tax Rate (in per cent)	12	12
Revenue Increase due to raising compliance from 25% to 33% (in lakh crores)		2.9
Net Income Transfer (NIT) / Direct Cash Transfer (DCT)
Tax rates (t per cent)	15	12
Constant (in rupees)	30000	30000
Max income receiving NIT/DCT (in lakh)	2.0	2.5
Cost (in lakh crore)	3.77	2.92
Source: Author's calculations based on Direct Taxes data from - http://www.incometaxindia.gov.in/Pages/Direct-Taxes-Data.aspx Note: *Taken from 2013-14 value # Using 2013/14 actual MOF data to make projections with the same characteristics e.g. compliance etc. **Source - NSS Survey 1. Implicit Rate of Taxation = 100*(Average Tax / Average Income Tax Payers) 2. Compliance Numbers = 100* (No. of taxpayers / Workers in the economy with incomes>2.5 lacs) 3. NIT / DCT = Constant - tY ; where 't' is the tax rate and 'Y' is the income

A version of this article appeared in the Indian Express, on January 14, 2017 under the banner "Towards an Income Tax Revolution"