High tax breaks, high gross revenue projections

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Successive Finance Ministers have continuously used the bogey of low tax revenue (gross) GDP % ratio to justify raising existing tax rates and/or levying new taxes. Let me explain. 

Consider, first of all, that the national GDP figure includes three sectors i.e. industry, services and agriculture while tax revenues include two sectors i.e. industry and services because agricultural income is tax-free - no state government having as yet displayed the courage or the imagination to levy a tax on agriculture. Most people are unaware that income tax on agriculture is within the domain of State Governments not the Centre. Therefore, the numerator (tax revenues) comprises of two sectors and the denominator (GDP) includes three sectors. In a country where agriculture contributes about 22% of India’s GDP, its inclusion in the total GDP figure can only depress the tax GDP ratio.

If we were to use the current method of indicating tax / GDP ratio the Revised Estimate for 2003-04 is 9.2% (Gross Tax Revenues Rs 2,54,923 crs, GDP at Rs 27,72,194 crs - current prices per Central Statistical Organization data). However, if agriculture and allied sector’s GDP (22.1%) is excluded from the total GDP, the tax GDP ratio shoots up by 28.2% to 11.8%. In years when agriculture constituted in excess of 30% of India’s GDP the actual tax GDP ratio was higher. 

The latest Budget has also used low tax GDP ratio % to justify fresh taxes / introduction of new ones. Further it has made some aggressive assumptions w.r.t increase in revenues. This article seeks to analyze the estimated increase, benchmark it with past trends and look at the revenue impact of specific direct tax proposals.

We now turn to a detailed analysis of the assumptions for increase in gross revenue. The table throws up some interesting analysis. (BE is 2004-05, RE is 2003-04,  2002-03 is Accounts).

Gross Tax Revenue Numbers - Trends                      Rs crs

Financial Year 2001-02 2002-03 RE03-04 BE 04-05
Real GDP Growth % 5.8 4.0 8.2 6.5
Agriculture 6.8 -5.2 9.1 3
Industry 3.3 6.4 8.7 8.7
Services 6.6 7.1 4.8 4.4
Centre Fiscal Deficit as a %of GDP 6.2 5.9 4.8 4.4
1.Gross Tax Revenues 187,060 216,266 254,923 317,733
% incr compared to p/year -0.8 15.6 17.9 24.6
2. Corporation Tax 36,609 46,172 62,986 88,436
% incr compared to p/year 2.6 26.1 36.4 40.4
3. Taxes on Income 32,004 36,858 40,269 50,929
% incr compared to p/year .8 15.1 9.2 26.5
4. Customs 40,268 44,852 49,350 54,250
% incr compared to p/year -15.3 11.4 10.0 9.9
5. Union Excise Duties 72,555 82,310 92,379 109,199
% incr compared to p/year 5.9 13.4 12.2 18.2

Source  - Budget documents 2004 and Receipts Budget 2004.

• Gross Tax Revenues are assumed to go up by 24.6% in BE vs. 17.9% in RE and 15.6% in 2002-03.
• Corporation Tax is assumed to go up by 40% in BE vs. 36% in RE and 26% in 2002-03.
• Taxes on Income other than corporation tax are assumed to go up by 26.5% in BE v 9.3% in RE, and 15.1% in 2002-03.
• Union Excise duties are assumed to go up by 18.2% in BE vs. 12.2% in RE and 13.4% in 2002-03.
• Customs are assumed to go up by 9.9% in BE vs. 10% in RE and 11.4% in 2002-03.

Starting 1995-96 only once i.e. in 1999-2000 did gross tax revenue grow at close to 20%. That too was on a lower base of Rs 143,797 crs in 1998-99 as compared to a higher base of Rs 254,923 crs in RE 2003-04. Further gross revenue growth at 17.9% in RE 03-04 is based on a real GDP growth of 8.2% while the economy is expected to grow at 6.5% in BE. Hence, Finance Minister Chidambaran’s assumption that tax revenues will grow by 24.6 % in the coming year seems far-fetched, even after considering the increase in the existing service tax rate, the extension of the service tax to a larger universe, the 2% education cess and the increase in excise on steel from 8% to 12%.

The core question is: Can the economy grow at 8% again? Remember, that besides 2003-4, an 8% plus growth rate was achieved only thrice in the last fifty fours years – 1967-68 (8.1%), 1975-76 (9.0%) and 1998-89 (10.5%). Moreover, the Finance Minister’s projected growth rate of 6.5% assumes inflation staying within the 5.5% range. Inflation is currently hovering around 6.5 %. The Congress led UPA government has increased petrol prices by 8.55 % (Mumbai Rs 38.83 to Rs 42.15) in two months. And mind you, the full impact of increases in oil prices and service tax rates is yet to be felt.

Interestingly a continuous increase in global oil prices and depreciation of the rupee might ensure that the Finance Minister’s meets his tax revenues targets. “And each dollar increase in global prices nets the government Rs 250 crs more of customs revenue, Rs 600 crs of excise, and around Rs 800 crs of additional corporate taxes”. Business Standard editorial of August 2,2004.

Coming to Corporation Tax some of you might argue that, inspite of a fall in GDP growth; a 40% growth in revenues is achievable since industry growth rate is likely to be maintained at 6.7%. Conversely, in 2002-3 industry grew at .3 points lower i.e. 6.4% yet revenues from corporation tax were Rs 46,172 crs or 52% of BE projections. Another reason why direct tax targets might not be met are the various tax concessions given by the current and previous budgets. Some of them are discussed below.

Budget 2003 introduced a Tax holiday in respect of certain undertakings in Himachal Pradesh, Sikkim, Uttaranchal & North Eastern states (section 80IC applicable from assessment year 2004-05). If the conditions laid down in the section are satisfied 100% of the profits and gains of the industrial undertaking are exempt from tax for atleast five years. Not only that but also all units set up in Himachal & Uttaranchal enjoy 100% excise exemption for ten years. The full impact of this concession might be felt only this year since it takes time to set up a factory there. Typically non-core sector industries like fast moving consumer goods, pharma and consumer durable companies are most likely to set up their factories in these states. Hence, industrial growth need not necessarily result in tax growth.

Incidentally, such tax holidays were provided in the past too to undertakings in Sikkim but offering such incentives in the newly carved state of Uttaranchal is a different Matter altogether. Earlier tax holiday states were situated in the hills; far away from consuming markets meaning companies had to incur huge transportation cost to transport raw materials to factory and thereafter finished goods to consumers. By virtue of parts of the state being in the plains and proximity to North Indian markets transportation cost are low in comparison meaning Uttaranchal could be a perfect investment destination for certain corporates. From their perspective it is perfectly legitimate and sensible to increase operating margins and post tax profits by shifting manufacture of high margin products to these states.

An earlier budget by the NDA government allowed a deduction of 100% profits to an undertaking developing and building housing projects if a local authority approved the housing project before 31st March 2005 (section 80 IB). Some of the key conditions are that development of the housing project should have commenced after 1/10/1998; plot size was to be a minimum of one acre. What this means that builders who satisfy prescribed conditions do not have pay tax on all new housing projects.

As if the above tax breaks were not enough the Finance Minister has introduced another provision to help Mumbai’s builders. It is a relaxation in the condition of minimum plot size of one acre in case of housing projects, as long as the projects are implemented in accordance with a scheme for reconstruction or development approved by the Central/State Government. What this means is that profit made from redeveloping Mumbai’s slums and probably mill lands would be tax-free. Although this provision will take effect from 1/4/2005, with the millions of square feet being developed in Mumbai the tax loss could be significant. Critics might argue that it is a price for coalition politics but then we should not be complaining about low tax GDP ratios.

How many of us know of these tax provisions? One is yet to hear of a builder who has passed on this tax break to the consumer.

It is not my intent to blame companies who take advantage of legitimate tax breaks. The point being made is that such tax concessions impact revenues adversely forcing the Government to levy new taxes on all taxpayers alike. Two recent examples are the 2 % education cess and increase in service tax rates.
The Government needs to rethink its policy of using tax breaks to promote growth. A number of companies are already shifting their manufacturing facilities from the erstwhile tax havens of Daman/Silvassa to Himachal & Uttaranchal.  Is giving tax breaks the only way to promote regional growth, development of backward states?

Tax sops and a depreciating rupee should cease to be a source of competitive advantage for sections of India’s manufacturing and Information Technology industries. As some sectors have shown innovation, quality and improved service levels should be the new mantras for success.

For reasons referred to above the ordinary man or aam aadmi perceives the more vocal & powerful taxpayer to get tax concessions while he is being increasingly taxed (now indirectly through widening of service tax net and increase in rates).

The Finance Minister has stated that the gross tax revenue projected by him assumes a realization of Rs 18,000 crs of undisputed arrears from direct and indirect taxes or about 17% of total tax arrears. It is surprising that he did not reveal even a part of the logic or strategy of how he hoped to collect such a large sum within the next nine months. Should the common man then be prepared for another amnesty scheme that will once again reward the dishonest sections of our society?

Revenues from Turnover tax in its original form were expected to yield Rs 7,000 crs. Its watered down version would generate revenues of about Rs 1,000 crs. This implies a straight 1.89% reduction in the Centre’s BE gross tax revenues of Rs 317,733 crs.

Overall, the revenue estimates are very optimistic. If not met the resulting deficit would impact both Central & State governments.

Rs 82,227 crs or 25.87% of the BE gross tax revenue is the states share of central taxes. What happens if the projected increase in gross tax revenue is not realized? Besides increasing the Centre’s fiscal deficit it would reduce transfer of funds to states.

For e.g. Bihar is allocated Rs 9,535 crs being 11.60% of the states share of central taxes ie Rs 82,227 crs. It has committed expenditure based on BE transfers. If these funds are not transferred the State could either cut back committed expenditure or make up the shortfall through market borrowings.

Another example is the state of Karnataka. Its budget for 2004-05 projects a surplus of Rs 474 crs as against a deficit of Rs 471 crs in the previous year. Besides additional resource mobilization of Rs 450 crs the turnaround is mainly due to the sharply hiked central devolution by Rs 350 crs. In case actual transfers to the State are less than Rs 350 crs it would result in a lower surplus.

By calling for early elections, not listening to their inner voice, the NDA has made the nation go through avoidable pain caused by a quickly prepared UPA budget. If only general elections were held as scheduled the country would have had one more year of consistent policies. The Budget could have capitalized on public support, a successful disinvestment program, higher FII inflows and an 8.2% GDP growth to help India realize its potential, come closer to fulfilling its dream of becoming an economic power. 

Having said that, the NDA occupy the opposition benches today. For India’s sake let us hope the Finance Minister meets his targets to truly become India’s Sapno ka Saudagar.