Tirthankar Roy is arguably the finest contemporary scholar of Indian economic history. He has pointed out in one of his books that the Indian government has had to struggle with low tax revenue for a very long time—an issue that is resonant is our times as well.
Roy has provided data to show that the tax collected for every unit of economic output in India was very low compared to not only a colonial power such as Great Britain or an Asian success story such as Japan but also compared to colonized countries such as Malaysia or Sri Lanka. The government of what was then the Federated Malay States spent on average more than 10 times the money spent in British India per head between 1920 and 1930. Not all of this can be explained by differences in average incomes in these two British colonies. Data from the Maddison Project show that India had an average income of $726 in 1930 while Malaysia had an average income of $1,278, in terms of 1990 dollars.
It was the same story in the case of many other colonized countries. Ceylon spent three times more per head than British India. Once again, the difference cannot be explained by higher incomes alone. The same is the case for Siam and French Indochina. Roy says that a major reason for the poverty of the Indian State was the dependence on land revenue for a large portion of tax collections. These revenue were low as well as inflexible.
Much has changed since then. India is now a $2.2 trillion economy with a diversified base of economic activity. Its tax base is no longer dominated by land. Yet, the problem of low tax collections persists. The Economic Survey published in February said that India’s ratio of tax-to-GDP (gross domestic product) is 5.4 percentage points below that of comparable countries. Vivek Dehejia and Praveen Chakravarty have earlier shown in this newspaper that the tax-to-GDP ratio has barely budged since 1991.
The contemporary numbers tells us an interesting story. Around 48 million people file income tax returns in India; the actual number of people who pay tax is lower because of those who report zero tax liabilities. The number of people who were eligible to vote in the 2014 national election was 815 million. In other words, India has one direct tax payer for every 16 voters.
The imbalance between the number of people who pay income tax on the one hand and the number of people who can vote on the other hand has profound implications for the Indian social contract. It creates political incentives for successive governments to borrow money to buy votes rather than build an effective tax system that will spur economic growth. Citizens are also less likely to put pressure on governments to spend wisely on public goods. Of course, only direct tax payers have been considered here; almost every Indian pays indirect taxes on consumption.
The lack of an adequate tax base has several other implications. The Indian State is incapable of spending for national security, a modern welfare system or public goods from its tax revenue. It has to borrow heavily. The result is a persistent deficit bias in Indian fiscal policy. The very same elite that complains—depending on ideological persuasion—about the lack of national security or support for the poor or terrible roads is hypocritically at the forefront of ducking their tax responsibilities. Successful nation states cannot be built on widespread tax evasion.
Many libertarians make a virtue out of this problem. They argue that it is good that the Indian beast is starved of revenue. Some have overstated economic freedom in India because of the low level of tax collections. A sharp point made by libertarian economist Alex Tabarrok in the popular Marginal Revolution blog is worth reproducing here: “A key point is that only 1% of India’s population pays income tax. India would be a libertarian paradise if it had a libertarian government but it doesn’t. As a result, what low income tax payments mean is that India is forced to raise money in less efficient ways and to govern through regulation.”
Tabarrok goes on to argue that most of the tax burden falls on the precisely the high-productivity sectors that need to grow. He adds: “India’s dilemma is that its high-productivity sectors are taxed while its low-productivity sectors aren’t, so valuable resources are trapped in low productivity sectors. (Prime Minister Narendra) Modi knows this and if he is serious then his surprise demonetization will be followed by more efforts to bring India’s informal sector into the formal sector, levelling the playing field, and increasing total wealth.”
Many commentators have speculated whether an exogenous shock such as the ongoing currency reform can change citizen behaviour in India, be it shifting to digital payments or paying taxes or encouraging enterprises to shift from the informal to the formal economy. It is even doubtful whether a behavioural shift was the original intent of the decision to withdraw bank notes of high denomination from circulation—though the Modi government seems to be rebuilding the narrative in that direction over the past few days.
Could a radical change in Indian fiscal contract be an unintended consequence of the ongoing currency swap? Nobody can say for sure, but it is an interesting possibility.