Income Tax Reform II: A feasible Negative Income tax/Net Income Transfer (NIT)

with Surjit S. Bhalla

    In our Jan 14 article, Towards an Income Tax Revolution, we had outlined what we believe is a major opportunity for the Modi government to bring in a structural reform to our income tax structure. What we suggested, and expand today, is an integrated approach to both taxation and redistribution. The latter can take, and has taken, many forms over the years. Technology (Aadhar), and political will (demonetization) allows India to finally begin to think BIG, and efficiently, in terms of redistributive policies.

But the two are necessary, not sufficient, for successful implementation. There is money involved, and the last thing the Modi government should do is to revert back to the bad old days of “in the name of the poor” corrupt policies like PDS, NREGA, loan waivers, fertilizer subsidies, etc. There is buzz around that the Budget might contain a Basic Income policy. One of us (Surjit) had offered a discussion of how Rs. 1000 per person per month could be transferred to every one in the bottom half of the population, and that the cost would be Rs. 5 lac crore (trillion). As Subhashis Banerjee has correctly pointed out (A Contentious Proposal, Indian Express, Jan 14, 2017), the calculations are incorrect if transfers have to be made to the bottom 50 %; the calculations are correct if transfers are to be made to the bottom 20 %, the percentage poor according to the upwardly adjusted poverty line of Rs. 1525 per person per month. The Tendulkar poverty line for 2016-17 is a lower Rs. 1250 per person per month. The error is unfortunate, and regretted.

Negative Income Tax: We are proposing, in lieu of basic income for all or even for a targeted population, that each non-farmer worker (hereafter just worker) receive a transfer upto a maximum of Rs. 15000 a year. The negative income tax is obtained according to the formula 15000 – 0.05*income of worker (upto an income of Rs. 3 lacs). In the aggregate, for about 240 million workers (72.7 % of the worker population) the total outgo for NIT is Rs. 1.70 lakh crores or an average of Rs. 7100 per earner recipient of NIT.

The Tendulkar poverty line, for a family of five, in 2016-17 prices, is Rs. 75000 a year. According to NSS data, the average number of earners in a poor family are close to 3.1; even for a two earner household, the transfer will be equal to an average of Rs. 16000  (Rs. 8000 per earner). The average earnings for the bottom 25 % of earners is Rs. 90,000. Thus for these 25 %, the take home post NIT income is 2*(90000+8000) or Rs. 196,000 a year – i.e. well above the five person poverty level income of Rs. 75000.

Proposed Income Tax system: In several comments received over our previous proposal [Towards an Income Tax Revolution, January 14], the one overwhelming response was that while the flat tax rate of 12 % was appreciated, most felt that it was politically unrealistic in the Indian context. Hence, we now propose a new revenue neutral system. This will be a two rate structure, 10 and 20 %. For the income range Rs. 3 to Rs. 6 lacs, the tax rate is 10 %; for those above Rs. 6 lacs, the tax rate is 20 %. Details are presented in the Table. Note that there is a loss of Rs. 1181 billion in the new system with compliance unchanged. What is noteworthy about tax compliance in India in 2013-14 is that while tax compliance for those earning less than Rs. 10 lacs was close to 30 %, the rate for those earning more than Rs. 10 lacs is as low as 20 %. As the PM had mentioned, in 2013-14, there were only 2.4 million earners with income above Rs. 10 lacs – our NSS distribution for 2016-17 suggests that the number of workers in this category is around 12 million.

Why should our numbers/estimates be believed? For two reasons: the mean income of our constructed distribution matches the mean income as obtained from national accounts (this is by construction!). Second, and more importantly, official tax receipts for each of the years 2011/12 to 2015/16 broadly matches (within 10 percent)  the receipts obtained via our synthetic distribution. Note that compliance rates are estimated via the number of official taxpayers (MOF data, 2013/14) and the taxpayers as per the constructed distribution.

There are significant gains for all workers in the new system. A person earning Rs. 4 lacs has her tax liability reduced by 35 %; for those earning Rs. 8 lacs, the tax liability is reduced by 20 %, and for those earning Rs. 16 lacs, the reduction is 27 %. A minimum set of compliance changes assumed by us are as follows: all compliance in the new tax regime is estimated to be 40 percent.

With this change in compliance, the new system will still entail a loss of Rs. 640 billion. This will still mean that only 4 out of 10 workers actually pay taxes in India. In the US, 85 of every 100 people pay taxes. We will still have a very long way to go – but we can begin to get there!

This loss can be made up either by another few percentage points increase in compliance (even with the reduced tax rates, we are assuming only a 40 % compliance rate) or by removing all budgeted tax incentives. In 2015-16, total incentives for tax payers was Rs. 550 billion, with Section 80C (mutual fund investments for rich taxpayers!) accounting for a fat Rs. 450 billion. There is no need for this payment to the rich in the new system – hence, removal of this exemption, is able to reduce the tax loss in the new system to practically zero; actually, a small loss of 90 billion.

What remains is the financing of the NIT. As outlined above, the cost of NIT is Rs. 1.7 lakh crores. If NIT is part of official tax policy, then there seems to be precious little need for anti-poverty programs like PDS or NREGA. These programs are not only costly, but also involve a lot of corruption -as most analysts (and us), and politicians, have pointed out over the years. Starting with Rajiv Gandhi, who in 1985 stated that only 15 % of the money meant for the poor actually reached the poor! Currently, total expenditure on these two wasteful programs is Rs. 1.75 lakh crores. If the government decides to eliminate other in the name of the poor (but not benefitting the poor) programs, then the net income transfer (NIT), per worker, can be increased.

With the adoption of this new thinking, and new anti-poverty policies, absolute poverty will be zero in India, and according to a much higher poverty line. And with no extra cost. The only assumption we are making in the tax reform is that tax compliance rates have to increase to 40 percent. The de-monetization policy has provided the stick for increased tax compliance – our proposed policy provides a much needed carrot.

Revenue Neutral - a Two (10 & 20 %) Income Tax Policy
Range	Existing Tax	New Tax	Reduction in Tax Paid	Number of Workers	Revenue Loss
					Average	Total	With Greater Compliance
(in lacs)	(At upper end of range)		(in per cent)	(in million)	(per worker)	(in billions)	(in billions)
3 - 4	15450	10000	35.3	7.8	5150	40	30
4 - 8	87600	70000	20.1	10.4	15000	156	117
8 - 16	316000	230000	27.2	7.0	95000	665	333
> 16	790000	470000	40.5	1	320000	320	160
Total				26.2	45083	1181	640
Note: Proposed Tax Rates : 0-3 lacs : No Tax; 3-6 lacs: 10%; and above 6 lacs: 20%; average income >16 lacs estimated to be Rs. 28 lacs 1. Reduction = 100 x ("Existing Tax" - "New Tax")/"Existing Tax" 2. Total Loss = Number of Workers x Average Loss per worker 3. Tax revenue loss with greater compliance has been calculated with compliance increase of 10 % points for ranges 3-4 lacs and 4-8 lacs, while a compliance increase of 20 % points for the range 8 -16 lacs and 16 lacs & above.

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A version of this article appeared in the  Indian Express, of  January 19, 2017 under the banner, " Taxing your way to popularity."

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"