Did windfall gain from cheap oil encourage Modi govt to take fiscal gambles

Demonetisation and the Goods and Services Tax are the biggest economic policy changes by the Modi government. Both of them are expected to reduce tax evasion. It is ironic that the fiscal deficit is expected to increase rather than decrease after these policies.

The government’s economic advisers think these policies have been successful. Writing in The Indian Express Surjit Bhalla, a part-time member of the PM’s economic advisory council, has said that the increase in direct tax compliance is demonetisation’s biggest achievement. He argues that direct tax buoyancy in 2017-18 is likely to be the highest in a decade.

Tax buoyancy is change in tax collection per unit change in GDP. So a higher figure would suggest greater tax compliance. An example will make this clearer. Suppose there are 10 persons earning Rs 1000 each in an economy. Let us assume an income tax rate of 10%. If everybody paid taxes honestly, total tax collection would be Rs 1000. Let us assume these incomes doubled to Rs 2000 each in the next year. Total tax collection would increase to Rs 2000. Since both income and taxes have doubled, tax buoyancy would be one. Now let us assume that two people concealed the increase in their incomes from tax-authorities. Total tax collection would be Rs 1800 in this case. Tax buoyancy would fall to 0.8.

A significant increase in tax buoyancy post-demonetisation would mean that a lot of people who did not declare their incomes earlier have been forced to do so. Bhalla also claims the increase in tax buoyancy is not a temporary spike (more on this later). He goes on to claim that GST would further increase buoyancy of both direct and indirect tax collections (http://bit.ly/2Dj0ry4). These claims suggest that there has been a big improvement in tax-collection capabilities under this government. There are good reasons to be sceptical about such sweeping claims.

First of all, any long-term comparison of tax buoyancy in India is an inconsistent exercise. This is because our national income data is not comparable over time. In 2015, India shifted to a new series of GDP with 2011-12 as the base year. Normally, a base revision exercise also gives adjusted numbers for previous year’s national income estimates. However, the latest series only gives national income figures till 2011-12. This means that the new GDP series would not have annual growth figures for the period before 2012-13. Tax buoyancy comparisons before this period would have to rely on 2004-05 GDP series numbers. An example can illustrate the problems with such an exercise.

We have growth numbers from both series for 2013-14. Annual growth in Gross Value Added (GVA) as per the new series is 12.61%. Gross Domestic Product (GDP) growth is 11.54%. Direct tax revenue grew at 14.9% in 2013-14. Depending on which series one is using, direct tax buoyancy can be either 1.18 or 1.29—a variation of almost 10%. It is better to avoid such methods.

Let us look at movements in tax buoyancy in the period between 2012-13 and 2017-18. Our calculations show that it has actually fallen by 10% between 2016-17 and 2017-18.

This trend holds for both direct and indirect taxes. The fall in indirect tax buoyancy is much greater. Overall tax buoyancy in 2016-17 and 2017-18 is still greater than what it was in 2014-15 and 2015-16. The latter two were drought years.

What about long-term trends in revenue growth? This comparison too, would have its limitations. Change in inflation and GDP growth would influence nominal revenue. Low inflation can lead to lower nominal tax collections, while higher income growth would increase tax collections. These factors vary over time. This is why tax buoyancy is a better exercise to check revenue collection abilities. Since a long-term comparison in tax buoyancy is not possible, we do this as the second-best exercise. The numbers do not support claims of an extraordinary improvement in tax collection growth post demonetisation.

Year-on-year growth in direct tax collection in 2016-17 and 2017-18 is much less than the levels during the boom years under the United Progressive Alliance in its first term. The spike in direct tax collection in 2016-17 could be just base effect. Direct tax collection registered negative growth in 2015-16. One could argue that demonetisation’s gains are actually reflected in 2017-18 growth in income tax collections. The question is whether it is a trend or a flash in the pan.

It is important to understand the concept of stock and flows to answer this question. Let us assume that a businessman was under-reporting his income by Rs 10 lakh every year for five years before demonetisation. Assuming a 30% income tax rate this would mean an income tax evasion of Rs 15 lakh. It is unlikely that all of this money was kept in demonetised currency notes. The person could have bought gold or used this cash for payments in cash. Let us assume that he had Rs 20 lakh in demonetised cash. He could have declared a part of this cash stock as this year’s income. Some of it could have been rerouted in the name of relatives or employees. Anecdotal accounts and the fact that more than 99% of the demonetised currency came back to the banking system support such possibilities. Such people could go back to under-reporting their incomes from next year. In that case, the income tax benefits of demonetisation could be transient. We need to wait for a few years to conclude whether or not this has been the case. There is a fair bit of speculation in Bhalla’s claim that increase in income tax buoyancy post-demonetisation is not a temporary spike.

Last year’s Economic Survey was also careful in declaring permanent income tax gains from demonetisation. The survey compared the growth in number of tax payers and average taxable income in post-demonetisation period (November 9 to March 31) during 2016-17 and 2015-16. It estimated an addition of 5.4 lakh tax payers and Rs 10500 crore in income taxes due to demonetisation. However, there was no significant increase in average taxable income. This increased from Rs 2.5 lakh to Rs 2.7 lakh. The survey says, “The full effect on collections will materialize gradually as reported income of these taxpayers grows”.

The demonetisation exercise was not without its costs. The slowdown in economic activity took a toll on earnings and profits. The government lowered its 2017-18 corporate tax collection, a tacit acknowledgement of this fact (See Chart 2). The policy had other costs as well. RBI’s dividend to government for the year ending June 30, 2017 has fallen by more than Rs 35000 crore. This is thrice the additional income tax gains estimated by the Economic Survey.

There are other worries on the tax front too. A 2017 Mint analysis by Tadit Kundu had shown that entire reduction in fiscal deficit in recent years was due to fall in crude prices. Rising oil prices would have the opposite effect. High petroleum tax rates can lead to an inflationary spike. The last thing a government would want in an election year is rising inflation. Non-petroleum indirect taxes collections are mired in GST-related uncertainties.

In 2015 Narendra Modi had linked falling oil prices with his good fortune. That has clearly reversed with rising oil prices as 2019 elections come closer. It would have helped if the government’s tax reforms had yielded desired results in the short run.

This is the last of a two-part data journalism series in the run up to the budget. The first part discussed economic roots of rural anger.