'Only tax breaks may not draw investors'

Global tax experts are keenly watching India's attempts to reform its indirect and direct tax regimes. Alan J Auerbach, director of the Burch Centre for Tax Policy and Public Finance and former chair of the Economics Department at the University of California, Berkeley, was in New Delhi to deliver the Raja Chelliah Memorial Lecture. He spoke to Jyoti Mukul on the risks of granting exemptions, and how the US tax stimulus was flawed in some ways. Excerpts:

Do tax incentives help promote investment?

They can play an important role. We have a similar practice in the US. Different states have their own taxation policies, often quite generous. In the US context, high taxation does discourage investment. But taxation is only a part of the overall thing. Regulations are also a very important consideration.

Often states that have high taxation have very onerous regulatory regimes. A favourable tax regime is certainly just one component for attracting business activity but the most important thing is whether there are regulatory hurdles.

When should a country move away from exemption-driven development and just bring overall tax rates down?

It is a difficult decision because, on the one hand, the exemption approach gives more flexibility to a particular industry; on the other, it is susceptible to ransacking activity by lobbying groups.

The exit depends on how successfully the government practises its exemption policy - whether it is able to give exemptions only if there is a real economic benefit. The success of the exemptions depends on how economically-beneficial and uncomplicated they are.

Does the US also give tax exemptions to the infrastructure sector for few years to promote its development?

Our construction firms don't get exemptions but they get generous government contracts. I would say that the only industry that has some kind of tax exemption is the natural-resource extraction industry - oil drilling. It's not so much the refining process that gets the exemptions as it is the energy exploration process.

This is because they have support of powerful members of Congress. Then there are non-profit making industries - for instance healthcare, hospitals in particular, is tax-exempt though there are taxable health providers also.

A lot of these exemptions come with a sunset clause but as the time for their expiry nears, there is lobbying for extension. On the other hand, there are instances where policy changes are made mid-term, like in the case of natural gas which was removed from the category of mineral oil for the purpose of tax holiday. Should governments stick to sunset clauses?

In ordinary circumstances, they should be adhered to. For instance, if there is tariff protection to protect a particular industry, there is always a temptation to continue. If the reason for tariff protection is there, they should be continued. I think clarity in government policy should be there.

Did fiscal incentives play a role in preventing a deeper economic slowdown?

I think they did. It is hard to know how big the impact was because there is no constant base line. Based on the forecast of what might happen, certainly in the US, industry is better now than what people thought it was six months ago.

Part of the effect was on the psychology of individuals. When Obama took over as US president, there was real paralysis in the market in the US. There was fear in households of wealth being wiped out. Business was finding it difficult to get credit. To have a government seen to be trying to deal with the problem, itself had a positive impact.

When we had stimulus packages, there were improved government spending and tax cuts. Some tax cuts are more effective than others. For example, the family tax cut in the US. I felt that it could have been better to target lower-income households because they have the propensity to consume more than others.

For political reasons, most households got it. It was the biggest tax piece. It was close to $200 billion over 10 years out of a total of $800 billion over 10 years.

India's stimulus measures have meant a huge deficit. How far is this approach correct and when should the stimulus measures be rolled back?

I think the answer for India is the answer for the US. In the short run, while you are recovering, you should not worry about deficit. India is doing better than the US. When a country falls below its normal growth path because of lack of effective demand, deficits can be allowed to rise very significantly.

The problem in the US was that when the economy was doing well, the then President George Bush went for huge tax cuts that created a deficit. He thought government spending was good and low tax was good, politically. George Bush pursued a deficit policy. Our deficit in 2009 is 11 per cent, and in 2010, it will be 10 per cent. Those deficits are high because of recession.

If I were in the Indian government, I would look at the growth projections in the next year. If it is a good and normal growth number, I would go for roll back.

The tax-to-GDP ratio in developing countries is low. As countries develop, they are able to collect more tax. The ratio at all levels of government in the US comes close to one-third of GDP. It is 18 per cent at the federal level alone, and 15 per cent at the state level. It is higher in Europe. Developing countries also need revenue for more public spending and that should happen.

India is in the midst of reforming its tax system. It has a direct tax code looking at phasing out exemptions and lowering tax rates, and an indirect tax regime which introduces uniformity and stability through a goods and services tax. Considering we are emerging from a slowdown, is this the right time to introduce these measures?

There is nothing in the tax reforms that make them dangerous now. Undertaking tax reform is a good idea regardless of the current growth rate. It should be accompanied by information technology and a good enforcement policy.

Investment will be a natural consequence of tax reforms. The kind of reforms India is considering will promote investment and employment. India is famous for its heavy regulatory environment and issues of inter-state governance.

While we are debating the structure of the GST, a consensus is yet to be reached with regard to exempted items. What is your view?

We have similar fiscal furores in the US. What we have is sales tax and not GST. Some sort of national uniformity is good. The European countries have too many exemptions in the system for reason of equity. There are other ways of providing equity like transfer payment and cut in direct taxes.

Those are concessions granted to individuals rather than to commodities. The problem of lower rate on commodities is that you subsidise purchases of those commodities. Economists want few exemptions but politicians do not have the same view.

What about alcohol, petroleum products and tobacco? Should they be under its purview?

You can have GST on them and have an additional tax. There are health reasons for having tax on alcohol and tobacco. The reason for taxing petroleum products at higher rates is to reduce congestion and pollution. If you are worried about urban pollution, that wouldn't be the argument for high tax on all petroleum products. Products used for manufacture of commodities like fertiliser should not be taxed at higher rates.