A direct tax league table for states can improve compliance 


As July turns into August and the second wave of covid mutants’ wanes, the temptation, after relentlessly fighting the havoc and mayhem of the last financial year, will be for government to enjoy a well-deserved rest. This would be a costly mistake. Now is the time for top decision makers to define a sustainable fiscal pathway.

The urgency is to constrain the growing public debt whilst retaining fiscal drivers for economic growth and social protection and bringing inflation in check. Despite the constrained spending for epidemic relief, the fiscal deficit is well above the acceptable level of 4 percent of GDP. Meanwhile, inflation is breaching the 6 percent mark and GDP growth remains contingent on stability in supply chains and normalization of civil constraints on movement and business. Given the low vaccination levels (8 percent fully vaccinated and another 27 percent with just one jab) continued bouts of epidemic related stress appear likely through the current year.  

The good news is that government has been decisive in containing the fiscal deficit by taxing heavily the hard to escape, but sadly, inflation enhancing excise tax on consumption of petroleum products. As a short- term strategy, tax gouging petroleum products is par for the course for the Union and the state governments. But continued relentlessly, it risks courting inflation.

Alternative tax sources, even if they are a tougher alternative, need to be pried open. One unorthodox option is to look harder at the set of Medium, Small and Micro enterprises (MSME) as greenfield sources for direct (income and corporate) tax. MSMEs figure in the public imagination as perennial recipients of government largesse – preferential interest rates, beneficial government procurement practices, state guaranteed collateral for loans and so on. 

63.4 million business enterprises qualified for the MSME tag in 2015-16 (NSS 73rd round). Of these a handful – 5000 are medium scale and another 0.3 million are small scale- together less than 0.5 percent in number. The presumption is that many of the small and medium enterprises would already be part of the 2.1 million businesses which paid direct tax in 2018-19. The issue is whether more profitable micro enterprises could be brought into the tax net?  

In June 2020, the 2006 classification of MSMEs was revised. The qualifying maximum investment level in plant and machinery, was increased from Rs 25 lakh to Rs 100 lakhs for micro enterprises, thereby cannibalizing some of the pre-existing “small” industries. A turnover ceiling of Rs 50 million was also added.

Out of the 63 million micro enterprises, 4.3 million are registered on the Udyog Aadhar Portal (July 2018). These are, most likely, active micro enterprises exporting, supplying to government agencies, part of supply networks, seeking credit facilities from banks and other activities which organized sector entities do, in the course of business. Clearly however, not all are filing a direct tax return or paying tax, since just 2.1 million businesses filed a direct tax return in 2018-19. We take a granular look at leading and lagging states in direct tax collections

MSMEs contribute one half of exports and one third of the manufacturing output. They employ 111 million workers. They are significant value creators. But in the thirteen largest states, each of which has more than a 2 percent share and together account for 85 percent of the national MSME output, the state’s share in production value, varies significantly from its’ share in direct tax collection. More significantly, even states grouped by the value of production – as a proxy for industrialization and urbanization- differ significantly in their share of direct tax collections. A lower share of direct tax collection versus leading states in the same group indicates that additional tax effort could increase the direct tax contribution. The table below summarizes. 

Production value 

Rs trillion (2006-07)

Leading states- share in direct tax collected (%) Lagging states – share in direct tax collected (%)
1 to 1.1  Tamil Nadu – 6.5% UP- 2.4%
0.7 to 0.8 West Bengal – 3.9% Kerala -1.5%, Punjab-1%
0.5 to 0.6 Andhra Pradesh (including Telangana) – 5.4%, Gujarat-4.3% Rajasthan – 1.5%, Haryana-2.6%, 
Source- Small & Medium production value as of 2006-07 (RBI handbook of State Finance)

Direct Tax collections Time Series (2018-19) GOI, MOF, CBDT.

 

Admittedly, this data set is inadequate for establishing statistical correlation. First, the production values are from the 2006-07 census whilst the direct tax collections are from 2018-19 – a decade later. Could small and medium production levels have changed significantly and lagging states be doing better? If so, then, their continuing low shares in 2018-19 direct tax collection, becomes even more inexplicable.

Production value 

Rs trillion (2006-07)

Leading states- share in direct tax collected (%) Lagging states – share in direct tax collected (%)
1 to 1.1  Tamil Nadu – 6.5% UP- 2.4%
0.7 to 0.8 West Bengal – 3.9% Kerala -1.5%, Punjab-1%
0.5 to 0.6 Andhra Pradesh (including Telangana) – 5.4%, Gujarat-4.3% Rajasthan – 1.5%, Haryana-2.6%, 
Source- Small & Medium production value as of 2006-07 (RBI handbook of State Finance)

Direct Tax collections Time Series (2018-19) GOI, MOF, CBDT.

 

Admittedly, direct tax collection is driven by multiple drivers, including the volume of salaried public sector workers and service providers, not just medium and small-scale production. Also, tax is paid on profit not on turnover. 

We control partially, for non-industrial sources of direct tax, by excluding states like Maharashtra, Delhi and Karnataka which have high direct tax collection shares in double digits and together contribute 47 per cent of the total direct tax. 

The remaining ten states are clubbed into three cohesive groups based on the value of small and medium production. The assumption here is that industrial production levels are broadly reflective of state capacity, income and expenditure. The question being asked is, that if Tamil Nadu and Uttar Pradesh have broadly similar nominal values for small and medium production why should the direct tax contribution share in Tamil Nadu be 2.7X of Uttar Pradesh? 

Similarly, why should direct tax collection in West Bengal be 2.6X of Kerala and 3.9X of Punjab or the direct tax collection share in Andhra Pradesh and Gujarat be respectively 2X and 1.7X of Haryana and 3.6X and 2.9X respectively, of the share in Rajasthan?

One reason could be that the tax compliance environment and governance levels in Uttar Pradesh, Kerala, Punjab, Haryana, and Rajasthan need to be enhanced to replicate the direct tax shares of better performing states in their group.

Tax governance capacity and a spirit of tax compliance will be critical in the coming months to bolster the fiscal capacity of the Union and state governments and deal with the continuing stress from the epidemic led slow-down. It is useful to identify the leading and the aspirational states, in the hope, that benchmark competition will lead to greater convergence. League tables come with many constraints, but they do generate convergence across competing entities. Let the tax convergence games begin! 

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Disclaimer

Views expressed above are the author’s own.



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