In the run-up to the Budget every year, trade and industry speculate on the changes in the tax regime. This year, there is a strong expectation in the industry that the tax rates would be reduced. This expectation has been buoyed particularly by the growth in tax receipts.
The finance minister, in response, is reported to have said that if there is increase in voluntary compliance, there may be a case for reducing the tax rate. So, the questions in the above respect are two-fold.
One, whether there has been an increase in voluntary compliance; and two, if there has been an increase in voluntary compliance, is it time to reduce the tax rates?
We have witnessed, in recent years, close to a 25 per cent increase in the direct taxes; last year's year-to-year growth was 39 per cent and in this year so far, the growth has been about 40 per cent.
Very often this surge in tax receipts is taken to mean an increase in the compliance rate. While this may partly be the case, we need to look a little deeper before coming to a conclusion on the matter.
Tax receipts are a product of tax rate, tax base and the compliance rate. While the tax rate and compliance rate may not change, the increase in the tax base due to growth in the size of the economy may result in an increase in tax receipts.
If we consider that the tax elasticity is 1.1, a back-of-the-envelope calculation would suggest that close to a 11 per cent increase in the tax receipts can be attributed to the growth in the economy. Since the inflation during these years has been around 6-7 per cent on an average, the increase in tax receipts due to the efforts of the tax administration can be roughly attributed to be around 8-10 percentage points. Such efforts by the tax administration should result in an increase in voluntary compliance.
But voluntary compliance is based on an incentive pattern. If it is felt that non-compliance may cost more, people would comply with the tax laws. But if it is the case that the cost of non-compliance is not likely to be high, evasion would be practised with impunity. Thus, an effective tax administration is important in fostering voluntary compliance.
Efforts of the Income Tax department in facilitating the speedy allotment of PANs, facilities for online preparation of tax returns and their filing, electronic clearing of refund payments, launching of Tax Return Preparer Scheme, and so on, may have certainly made the tax filing and tax payment easier and encouraged voluntary compliance.
But without sufficient and effective tax enforcement mechanism, voluntary compliance may not be there. This involves a feedback effect between voluntary compliance and enforcement mechanism, and it may not be really sufficient to back one at the expense of the other.
The tax administration needs to deal with both sides simultaneously; otherwise non-compliance would shift to the gap where the administration is weak. An efficient tax administration would, therefore, detect and penalise non-compliance, and facilitate voluntary compliance through the provision of quality taxpayers' service.
Thus, taxpayers' education and service, collection, collation, storage, retrieval and verification of information, along with the collection of taxes and grievance redressal system create synergies for an efficient and effective tax administration - some of these encourage voluntary compliance, and some are for enforcing compliance.
A model to separate the effects of voluntary compliance and enforcement mechanism on the tax receipts - Income Tax and Corporate Tax separately, has been developed by the author (along with A L Nagar at NIPFP, and published in the Economic & Political Weekly on Dec 15, 2007).
The voluntary compliance has seen a rise both for IT and CT in recent years; it was stagnant till 1995-96. But even if we consider the period from 1995-96 to 2006-07, the increase is only by 5 percentage points. This is certainly not an appreciable rise, but nonetheless significant, particularly during the last three financial years.
The increase in voluntary compliance from 2004-05 to 2006-07 has been 3 percentage points. This increase encourages trade and industry to demand cuts in tax rates. This answers the first question of whether there has been an increase in voluntary compliance.
On whether it is time to reduce the tax rates as there is an increase in voluntary compliance, the answer may not be so definite. Some may argue that the recent increase in voluntary compliance settles the question in affirmative for a tax cut, but sceptics may say that this increase is not as significant and any slowdown in voluntary compliance may affect tax receipts.
Normally, a cut in tax rate encourages voluntary compliance (Laffer's hypothesis), but the stability of tax revenues is also an important consideration for the government before any tax cut is attempted. One suggestion which can be made in this regard is to remove the surcharge. This will give the taxpayers a 3 per cent overall tax cut, and would encourage them to be more compliant voluntarily, given their performance in recent years.
For the tax administration, there would be a case for more investment if this increase in voluntary compliance is to be sustained and increased, particularly since the direct tax administration has seen a woeful decline in the cost of collection.
The present cost of collection is 0.6 per cent; in 1998-99 it was 1.8 per cent. Most OECD tax administrations spend between 1 per cent and 2 per cent. While there is no case for high spending, there is also no case for too low a cost of collection.
Very low spending may affect some of the modernisation programmes of the tax administration, both in terms of infrastructure and personnel training to adapt to the changing methods.
Both these needs are required for achieving a good mix of voluntary compliance and enforcement mechanism. Such an optimal mix would require reducing the cost of compliance for taxpayers and augmenting the capacity of the tax administration.
The author is from the Indian Revenue Services. The views expressed are personal.