2

ReportofTaskForceon

ImplementationoftheFRBM Act

16July2004

2

Contents

Preface ix

Members xi

1 Executivesummary 1

2 The fiscal challenge 152.1 Fiscaldeterioration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152.2 Evolutionof Tax/GDPratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152.3 Diagnosingthepoorperformanceon taxes . . . . . . . . . . . . . . . . . . . . . 162.4 Thecompositionof taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18

2.4.1 Theproblemof customs . . . . . . . . . . . . . . . . . . . . . . . . . . 202.4.2 Theproblemof taxationof services . . . . . . . . . . . . . . . . . . . . 222.4.3 Perspectiveon futureimprovements . . . . . . . . . . . . . . . . . . . . 23

2.5 Major componentsof revenueexpenditure . . . . . . . . . . . . . . . . . . . . . 232.6 FRBM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24

3 The baselinescenarioand its implications 273.1 Processfor mediumtermplanningandprojections . . . . . . . . . . . . . . . . 273.2 Interpretationof thebaselinescenario . . . . . . . . . . . . . . . . . . . . . . . 273.3 AssumptionaboutnominalGDPgrowth . . . . . . . . . . . . . . . . . . . . . . 283.4 Baselineexpenditureprojections . . . . . . . . . . . . . . . . . . . . . . . . . . 283.5 Baselinerevenueprojections . . . . . . . . . . . . . . . . . . . . . . . . . . . .29

3.5.1 Non-taxrevenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303.6 Projectionsaboutcapitalreceipts. . . . . . . . . . . . . . . . . . . . . . . . . . 323.7 Baselineprojectionsandtheir interpretation . . . . . . . . . . . . . . . . . . . . 32

4 Macro perspectiveon fiscal consolidation 374.1 Policy alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

4.1.1 Early versusdelayedadjustment. . . . . . . . . . . . . . . . . . . . . . 374.1.2 Cuttingexpenditureversusraisingtax revenues. . . . . . . . . . . . . . 37

4.2 Business-cycleconsiderations . . . . . . . . . . . . . . . . . . . . . . . . . . . 384.2.1 Closedeconomymultipliers . . . . . . . . . . . . . . . . . . . . . . . . 38

ii CONTENTS

4.2.2 Attenuationof fiscalmultipliersin anopeneconomy . . . . . . . . . . . 394.2.3 Wherearewe in thebusinesscycle? . . . . . . . . . . . . . . . . . . . . 394.2.4 Investment-ledgrowth . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

4.3 Otherconsiderations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .404.3.1 Lagsin policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .404.3.2 Flexibility oncapitalexpenditure . . . . . . . . . . . . . . . . . . . . . 414.3.3 Expansionaryeffectsof tax reforms . . . . . . . . . . . . . . . . . . . . 424.3.4 Positive impactonstatefinances. . . . . . . . . . . . . . . . . . . . . . 434.3.5 Needfor pre-announcedtrajectory . . . . . . . . . . . . . . . . . . . . . 44

4.4 Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

5 Policy proposals 475.1 Attainingafiscalcorrectionof 1.66%of GDPby 2008-09 . . . . . . . . . . . . 475.2 Strategy for tax reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .485.3 Thegoodsandservicestax (GST) . . . . . . . . . . . . . . . . . . . . . . . . . 51

5.3.1 Evolutionandproblemsof unionexciseduties . . . . . . . . . . . . . . 515.3.2 Evolutionof taxationof services. . . . . . . . . . . . . . . . . . . . . . 545.3.3 Integrationof unionexcisedutiesandservicetax . . . . . . . . . . . . . 555.3.4 Constitutionalpower to levy integratedgoodsandservicestax . . . . . . 585.3.5 Treatmentof capitalgoods . . . . . . . . . . . . . . . . . . . . . . . . . 585.3.6 Treatmentof petroleumproducts. . . . . . . . . . . . . . . . . . . . . . 595.3.7 Treatmentof small-scalesector . . . . . . . . . . . . . . . . . . . . . . 605.3.8 Locationbasedexemptions. . . . . . . . . . . . . . . . . . . . . . . . . 615.3.9 Treatmentof immovableproperty . . . . . . . . . . . . . . . . . . . . . 625.3.10 Treatmentof financialservices. . . . . . . . . . . . . . . . . . . . . . . 665.3.11 Treatmentof imports . . . . . . . . . . . . . . . . . . . . . . . . . . . .695.3.12 Power to taxservices:sharingit with thestates . . . . . . . . . . . . . . 71

5.4 Customsduty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .745.4.1 Ratestructure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .765.4.2 Tariff exemptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .785.4.3 Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . .79

5.5 Personalincometax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .795.5.1 Exemptionlimit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .815.5.2 Tax rates:singlerateor multiple rates . . . . . . . . . . . . . . . . . . . 855.5.3 Taxslabs:broad-basing . . . . . . . . . . . . . . . . . . . . . . . . . . 865.5.4 Taxconcessionfor savings . . . . . . . . . . . . . . . . . . . . . . . . . 865.5.5 Grandfatheringof savingsincentives:Whatdoesit imply? . . . . . . . . 955.5.6 Taxationof fundmanagement. . . . . . . . . . . . . . . . . . . . . . . 965.5.7 Redefining‘speculative transaction’undertax laws . . . . . . . . . . . . 985.5.8 Tax issuesonfinancinginfrastructuredevelopment . . . . . . . . . . . .106

5.6 Corporatetax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1105.6.1 Tax incentives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1125.6.2 Accelerateddepreciation. . . . . . . . . . . . . . . . . . . . . . . . . .116

CONTENTS iii

5.6.3 Tax incentivesundersections80IA and80IB . . . . . . . . . . . . . . .1205.6.4 Treatmentof corporatetax losses . . . . . . . . . . . . . . . . . . . . .1225.6.5 Implementationstrategy . . . . . . . . . . . . . . . . . . . . . . . . . .123

5.7 Strengtheningtaxadministration . . . . . . . . . . . . . . . . . . . . . . . . . .1245.7.1 Thetax informationnetwork (TIN) . . . . . . . . . . . . . . . . . . . .1245.7.2 Proposalson improving ‘normaloperationalprocedures’. . . . . . . . . 1275.7.3 Risk basedassessment. . . . . . . . . . . . . . . . . . . . . . . . . . .1285.7.4 Risk intelligencenetwork (RIN) . . . . . . . . . . . . . . . . . . . . . .128

5.8 Non-taxrevenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1315.9 Expenditurereforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .131

5.9.1 Publicgoodsversussubsidies . . . . . . . . . . . . . . . . . . . . . . .1335.9.2 Centralversuslocalpublicgoods . . . . . . . . . . . . . . . . . . . . .1335.9.3 Focusonpublicgoodsoutcomes. . . . . . . . . . . . . . . . . . . . . .1345.9.4 Achieving betterpublicgoodsoutcomes. . . . . . . . . . . . . . . . . .1345.9.5 Incrementalimprovementsin institutionalmechanisms. . . . . . . . . .135

6 Fiscalprojectionsunder reforms scenario 1376.1 Rationaleof projectionsunderreformsscenario . . . . . . . . . . . . . . . . . .137

6.1.1 Personalincometax . . . . . . . . . . . . . . . . . . . . . . . . . . . .1386.1.2 Corporationtax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1386.1.3 Unionexciseduties. . . . . . . . . . . . . . . . . . . . . . . . . . . . .1406.1.4 Servicetax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1416.1.5 Customs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1416.1.6 Summarisingtheimpactof proposedreformsonall taxcomponents. . . 1426.1.7 Summarisingbasisfor projectionsfor baselineandreformsscenarios . . 142

6.2 Major economicfeaturesof thereformsscenario . . . . . . . . . . . . . . . . .1426.2.1 Taxprojectionsfor reformsscenario. . . . . . . . . . . . . . . . . . . .1426.2.2 Fiscalprojectionsfor reformsscenario. . . . . . . . . . . . . . . . . . .143

6.3 Sensitivity of projectionsto shocks. . . . . . . . . . . . . . . . . . . . . . . . .1506.4 Needfor carein evaluatingalternativepolicies. . . . . . . . . . . . . . . . . . .151

7 Impact of achieving FRBM targets 1537.1 World classtaxsystem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1537.2 Impacton investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1547.3 Impactonmanufacturing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1547.4 Impactonexports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1557.5 Impacton thefinancialsector. . . . . . . . . . . . . . . . . . . . . . . . . . . .1577.6 Impactonstatefinances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1587.7 Impactonhealthandeducation. . . . . . . . . . . . . . . . . . . . . . . . . . .1587.8 Impactonprices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1587.9 Impacton theexpenditure/GDPratio . . . . . . . . . . . . . . . . . . . . . . . .1597.10 Impactondefenceexpenditure . . . . . . . . . . . . . . . . . . . . . . . . . . .1607.11 Reducedcrowdingout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160

iv CONTENTS

7.12 Complementaritywith otheraspectsof reform . . . . . . . . . . . . . . . . . . .1607.13 Impactongrowth andemployment. . . . . . . . . . . . . . . . . . . . . . . . .161

Appendices 162

A Estimation of tax buoyancies 163A.1 Questionsandmethods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .163A.2 Personalincometax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .163A.3 Corporationtax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165A.4 Non-POLExcise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165A.5 Summarising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .168

B Estimation of revenuepotential for a goodsand servicestax (GST) using firm-leveldata 169B.1 Questionsaboutrevenuepotentialfrom theGST. . . . . . . . . . . . . . . . . .169B.2 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .170

B.2.1 TheCMIE firm-level database. . . . . . . . . . . . . . . . . . . . . . .170B.2.2 Databasemethodology. . . . . . . . . . . . . . . . . . . . . . . . . . .170B.2.3 Servicessectorcoveragein thedatabase. . . . . . . . . . . . . . . . . .172B.2.4 Issuesin usingthisdatabasefor GSTestimation. . . . . . . . . . . . . .177

B.3 EstimatingpotentialGSTrevenuesusingfirm-level data . . . . . . . . . . . . .177B.4 Determiningaminimumsizefor levying aGST . . . . . . . . . . . . . . . . . .180

C The FRBM Act and associatedRules 183C.1 FRBM Act, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .183C.2 FRBM Rules,2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .187

D The Constitution (88th amendment)Act, 2003 199

E Termsof referenceof the task force 201

F Glossary 203

List of Tables

2.1 Largecountrieswith ahigh ratioof import dutiesto tax revenues(2001) . . . . . 222.2 Growth of interestandsubsidies . . . . . . . . . . . . . . . . . . . . . . . . . . 242.3 Requirementsof theFRBM . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

3.1 BaselineGDPatmarketprices . . . . . . . . . . . . . . . . . . . . . . . . . . . 283.2 Baselinetaxprojections(Rs.crore). . . . . . . . . . . . . . . . . . . . . . . . . 313.3 Baselinetaxprojections:Percentto GDP . . . . . . . . . . . . . . . . . . . . . 313.4 Evolutionof sourcesof non-taxrevenue . . . . . . . . . . . . . . . . . . . . . . 313.5 Fiscalprojectionsunderbaselinescenario(Rs.crore) . . . . . . . . . . . . . . . 333.6 Fiscalprojectionsunderbaselinescenario(Per centto GDP) . . . . . . . . . . . 35

4.1 Buildupof capitalexpenditureof NHAI . . . . . . . . . . . . . . . . . . . . . . 42

5.1 Somefour-yearepisodesof largeincreasesin theTax-GDPratio . . . . . . . . . 485.2 Exciserationalisation:1990-2004 . . . . . . . . . . . . . . . . . . . . . . . . . 535.3 Excisestructurefor petroleumand naturalgas (1June2004) . . . . . . . . . . . 605.4 VAT treatmentof immovablepropertyundertwo approaches. . . . . . . . . . . 655.5 GSTrates:internationalexperience . . . . . . . . . . . . . . . . . . . . . . . . 735.6 Evolutionof customsdutystructure . . . . . . . . . . . . . . . . . . . . . . . . 765.7 Tariffs andeffectiveprotectiononcrudeoil andproducts . . . . . . . . . . . . . 775.8 Evolutionof incometax ratestructure . . . . . . . . . . . . . . . . . . . . . . . 825.9 Presentincometaxstructure . . . . . . . . . . . . . . . . . . . . . . . . . . . .825.10 Incometax ratesof 1950-51 . . . . . . . . . . . . . . . . . . . . . . . . . . . .835.11 Growth of numberof taxpayers,acrossincreasesin theexemptionlimit . . . . . 835.12 Proposedpersonalincometaxstructure . . . . . . . . . . . . . . . . . . . . . . 865.13 Fundsmobilisedby financialinstitutionsthroughZCBs . . . . . . . . . . . . . .1085.14 Trendsin theeffectivecorporatetax rate . . . . . . . . . . . . . . . . . . . . . .1165.15 Calculationof accumulatedinternal accrualunder the existing corporatetax

regime(2003-04) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1195.16 Calculationof accumulatedinternal accrualunderthe proposedcorporatetax

regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .121

6.1 GDPatmarketpricesunderreformsscenario . . . . . . . . . . . . . . . . . . .137

vi LIST OF TABLES

6.2 Impactof proposedpersonalincometax reformson individual taxpayers. . . . . 1396.3 Estimatesof revenueimpactof proposedchangesto corporateincometax rates

anddepreciationrates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1406.4 Projectionof servicetax revenues . . . . . . . . . . . . . . . . . . . . . . . . .1416.5 Additional resourcemobilisation(ARM) by taxsource . . . . . . . . . . . . . .1426.6 Revenueassumptionsunderlyingbaselineversusreformsscenarios. . . . . . . . 1436.7 Expenditureassumptionsunderlyingbaselineversusreformsscenarios. . . . . . 1446.8 Reformsscenariotaxprojections(Rs.crore) . . . . . . . . . . . . . . . . . . . .1446.9 Reformsscenariotaxprojections:Percentto GDP . . . . . . . . . . . . . . . .1456.10 Fiscalprojectionsunderreformsscenario(Rs.crore) . . . . . . . . . . . . . . .1466.11 Fiscalprojectionsunderreformsscenario(Per centto GDP) . . . . . . . . . . .1476.12 Comparingbaselineandreformsscenarios. . . . . . . . . . . . . . . . . . . . .148

A.1 PersonalincometaxandGDP . . . . . . . . . . . . . . . . . . . . . . . . . . .163A.2 CorporateincometaxandGDP . . . . . . . . . . . . . . . . . . . . . . . . . . .165A.4 Non-POLExciseandmanufacturingGDP . . . . . . . . . . . . . . . . . . . . .165A.3 Breakupof excisecollections:POLversusNon-POL . . . . . . . . . . . . . . .166A.5 Summarisingbuoyancy estimates. . . . . . . . . . . . . . . . . . . . . . . . . .167

B.1 TheCMIE firm-level database: Coverage:2002-03 . . . . . . . . . . . . . . . .171B.2 TheCMIE firm-level database: SizeDistribution: 1999-00 . . . . . . . . . . . .172B.3 CMIE firm-level database: Coverageof ServicesSector . . . . . . . . . . . . . .174B.4 Sub-sectorsof the servicessector: CMIE firm-level databasecomparedwith

NAS, 2002–03 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175B.5 Industryclassificationof servicesfirms in theCMIE firm-level database(2002-03)176B.6 SummarystatisticsaboutCMIE firm-level database: 2002-03. . . . . . . . . . .178B.7 Estimatesof potentialrevenuefrom auniformGSTbasedonSalesin 2002-03. . 179B.8 Estimatesof potentialrevenuefrom auniformGSTbasedonGVA in 2002-03. . 179B.9 Estimatesof potentialrevenuefrom auniformGSTbasedonGVA netof interest

paymentsin 2002-03 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179

List of Figures

2.1 Trendsin revenuedeficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162.2 Trendsin gross fiscaldeficit . . . . . . . . . . . . . . . . . . . . . . . . . . . .162.3 Variationof Tax/GDPratiowith GDP(across51 largecountries) . . . . . . . . . 172.4 Evolving structureof GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . .182.5 Evolutionof GDPandtaxcomposition. . . . . . . . . . . . . . . . . . . . . . . 192.6 Evolutionof taxcomposition(sharein taxes) . . . . . . . . . . . . . . . . . . . 192.7 Evolutionof taxcomposition(percentto GDP) . . . . . . . . . . . . . . . . . . 212.8 Theshareof import dutiesin taxes(across51 largecountries). . . . . . . . . . . 212.9 HistoricalLiabilities/GDPratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3.1 NominalGDPgrowth, andGDPdeflator . . . . . . . . . . . . . . . . . . . . . . 293.2 Deficit projectionsunderbaselinescenario. . . . . . . . . . . . . . . . . . . . . 343.3 Improvementsin deficitsunderbaselinescenario . . . . . . . . . . . . . . . . . 34

4.1 Alternativepathsto eliminationof therevenuedeficit . . . . . . . . . . . . . . . 384.2 Fiscaladjustmentin theUS in the1990s . . . . . . . . . . . . . . . . . . . . . . 41

6.1 Revenuedeficit aspercentto GDP:Projectionsunderreformsscenario . . . . . 1486.2 Liabilities aspercentto GDP:Projectionsunderreformsscenario . . . . . . . . 1496.3 Interestpaymentsas per cent to revenuereceipts: Projectionsunder reforms

scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1496.4 Discretionaryexpenditureaspercentto GDP:Projectionsunderreformsscenario150

7.1 Treatmentof importsandexportsin aGSTframework . . . . . . . . . . . . . .156

A.1 Growth of personalincometaxaspercentof GDP . . . . . . . . . . . . . . . . .164A.2 Five-yearrolling window estimatesof buoyancy of personalincometax . . . . . 164A.3 Growth of corporateincometaxaspercentof GDP . . . . . . . . . . . . . . . .165A.4 Five-yearrolling window estimatesof buoyancy of corporateincometax . . . . . 166A.5 Growth of non-POLexciseaspercentof manufacturingGDP . . . . . . . . . . .167A.6 Five-yearrolling window estimatesof buoyancy of non-POLexcise . . . . . . . 167

B.1 Coverageof firms obtainedunderalternativesizethresholds . . . . . . . . . . .181

viii LIST OF FIGURES

Preface

This Reporton the Implementationof the FiscalResponsibility andBudgetManagementAct,2003, consistsof seven chaptersand associatedappendices.The proposalsoutlined hereareaimedto take our economyto a morecommandingpositionto take full advantagefrom greaterintegration with the growing world economyand thus enablethe country to achieve highergrowth, greateremploymentopportunities,enhancedeconomicsecurityanda moreequitableeconomy.

Chapters2 and4 of the reportdiscussthe backgroundandmacroeconomicissuesrelating tofiscal consolidation.Chapter3 discussesthe baselinescenarioandits implications. Chapter5outlinesthelogic andthepolicy proposals,for taxaswell asexpenditurereforms,to achieve therequiredfiscalconsolidation.

Among other things, this chaptercontainsproposalsrelating to the integration of goodsandservicestaxationandthe sharingof servicetax revenueswith the States.Theseproposalsareof vital importancein connectionwith the proposedState level VAT reformsandcanpossiblyform apartof a ‘grandbargain’ betweentheCentrewith theStatestowardsrationalisingall Statetaxesongoodsandservices.Thesereformsof State level taxationarecentralto thelong-standingpolicy goalof Indiaasacommonmarket,andfor obtaininginternationalcompetitivenessof ourfirms.

Our proposalson expenditurereformsare essentiallyin the natureof a policy approach,andwould require furtherdiscussionwith the PlanningCommission,administrative Ministries andotherstakeholders,to work outasharedprogramfor expenditurereforms.

Chapter6 gives the detailsof the revenueand expenditureprojections. AnnexuresA and Bprovide the “empirics” of the revenueprojections.AnnexureA givesestimatesfor the variousparametersusedin the revenueprojections. Annexure B gives estimatesfor revenuesfromthe integration of goodsand servicestaxes. Thesehave beenpreparedon the basisof datacollectedfrom the Centrefor Monitoring Indian Economy(CMIE). The CMIE databasecoversover200,000firms,usingtheirAnnualReportssubmittedto theDepartmentof Company Affairs.This is perhapsthemostcomprehensive firm-level databaseavailablein India. Theseannexuresprovidepartof theempiricalfoundationfor thepolicy proposals,andrevenueprojections, shownin thereport.

x LIST OF FIGURES

Chapter7 discussesthe economicimpact of achieving FRBM targets - i.e. how meetingFRBM objectives throughsystematicmodernisationof taxationandexpenditurewould give avery positive impulseto the economyin termsof promotinggrowth, employment,equity anddevelopmentindicatorssuchashealthandeducation.

In preparingthis report,we shouldacknowledgethe outstandingcontribution by Shri ArbindModi, IRS (IT), Dr. Ajay Shah,Consultant,Shri GautamRay, JS(TRU), Shri JayantSinha,DS (Budget)and Shri V. S. Chauhan,DS (Budget). Without their dedication,diligence andcommitmentto thegoalsof FRBM, wewouldnothavebeenableto bringsuchacomprehensivereportin soshorta time. Thedraftingof thereporthasbeendoneby Shri Arbind Modi andDr.Ajay Shah. We would like to placeon recordour deepappreciationandgratitudeto themfortheirsplendidwork. Wewouldalsolike to thankShriMadhusudanPrasad,Convenorto theTaskForcefor hissplendidcontributionto thework of theTaskForce.TheTaskForcewouldalsoliketo placeonrecordits appreciationof thesupportand assistancerenderedby officialsandstaff oftheMinistry of Finance.In particular, thesecretarialassistanceof S.Ravi, R. C.Anand,SantoshGupta,andJawaharPeswaniaregratefullyacknowledged.

Theproposedreformsareindeedbold reforms,andwe believe thatthesereforms,accompaniedby otherstructuralreforms,will takeoureconomyonapathof sustained“high qualitygrowth”.

New Delhi16July2004

Constitution of TaskForce

ChairmanVijay L. Kelkar Advisor to Ministerof Finance

MembersD. C. Gupta FinanceSecretaryVineetaRai RevenueSecretaryN. S.Sisodia Secretary(FinancialSector)D. Swarup Secretary(Budget& Expenditure)AshokK. Lahiri ChiefEconomicAdvisor

ConvenorM. Prasad JointSecretary(FRBM)

AdvisorsAjay Shah Consultant(Departmentof EconomicAffairs)Arbind Modi OfficeronSpecialDuty to Advisor to Ministerof FinanceJayantSinha DeputySecretary(Budget)

xii LIST OF FIGURES

Chapter 1

Executivesummary

Backdrop

India hasfacedpersistentfiscalproblemsforover a decade. The revenue expenditureof government has laggedbelow revenuereceiptsof government,giving largerevenuedeficits. Large revenuedeficitshave beenarecurring feature, year after year. Despiteenergeticefforts by a seriesof governments,the revenue deficit worsenedfrom 3.3 percent of GDP in 1990-91to 4.4 per cent ofGDPin 2002-03(seeChapter2).

A government that has a revenue deficitis taking debt in order to finance current(revenue) expenses. This recurrent bondissuancehas led to a substantialbuild-upof debt, and interest paymentshave risento enormous proportions. In 2000-01and2001-02, more than half of the revenuereceiptsof the governmentwereusedup inmerely paying intereston the accumulateddebt. In the 2004-05budgetpresentedon 8July, an enormoussumof Rs.129,500croreis required to merely pay interest on thisaccumulateddebt.If India hadprudentfiscalpolicies, this expenditurecould have foundalternativeuses.

The non-interest expenditures of govern-ment, which is the part where governmenthasdiscretionandcanchoosewhat kinds of

expenditureare desired,fell from 14.7 percentof GDP in 1990-91to 10.7 per centofGDP in 2000-01,a sharpdrop of 4 percent-agepointsof GDPover a one-decadeperiod.This reflectsthe ‘crowding out’ of the legiti-matefunctionsof government,in the faceofthesefiscalproblems.

The experienceof the last five years hasbeenrelatively benign,owing to the declinein interestrateswhich cameabout throughlower inflation rates.However, interestratesin thenext five yearswill not go down in thesamemannerthatinterestrateswentdown inthe lastfive years. This aspectconstitutesanadditionalsombreaspectof thedifficult fiscalsituation.

FRBM

The gravity of the situation, and a multi-yearprocessof debateanddiscussion,led toa far-sightedresponse.All political partiesvoted in favour of the Fiscal Responsibility

and Budgetary Management Act, 2003 (seeSection 2.6). This Act required that therevenuedeficitshouldbeeliminatedby 2007-08. An amendmentto this Act, which is partof the FinanceBill laid in Parliamenton 8July2004,proposesto shift thisdateto 2008-09.

2 Executivesummary

Under the amended Act, from 2008-09onwards, government would continue tobe able to issue bonds, within limits, butonly to finance capitalexpenditure whichcreatesassets. Taking on debt would notbe permitted in order to finance recurring(revenue)expenditure.

Thetaskof eliminatingtherevenuedeficitby2008-09appearslike adistantgoal.However,Rules under the FRBM Act additionallyrequire(amongotherthings)thattherevenuedeficit must come down by 0.5 percentagepoints of GDP every year, that the fiscaldeficit must come down by 0.3 percentagepointsof GDPevery year, andthat thefiscaldeficit in 2008-09mustbebelow 3 percentofGDP. AppendixC containsthefull text of theFRBM Act and associatedRules.This reportoutlines the strategy of policy measurestoachieve the targetsby 2008-09as proposedin theFinanceBill.

Medium-term fiscalplanning process

In the traditional annual budgeting frame-work, eachbudgetis viewedin isolation,andthehorizonof planningconsistsof oneyear.The FRBM framework hasenormouslyim-proved this budgetingprocessat several lev-els. At the level of annualbudgets,mini-mum targetsfor fiscal consolidationare re-quired for every year - suchasan improve-mentin the revenuedeficit of 0.5 percent ofGDPandanimprovementin thefiscaldeficitof 0.3percentof GDP.

TheAct alsorequiresthatgovernmenthastoembarkon a new conceptof medium-termfiscalplanning.This greatlydiffers from thetraditional annual budget process. A newkind of fiscal planning processis required,which looks beyond 2005-06all the way to

2008-09,in orderto achieve the targets,andin order to transparentlycommunicatethemedium-termfiscalstrategy to thenation.

This reportattemptsto addressthis questionof fiscal planning (see Chapter3) in twosystematicsteps.

Step I . First, a set of ‘baseline’ projectionswere made,whereby a detailedforecastingeffort was undertaken in order to estimatethe broadcontoursof Centralfinancesfrom2005-06to 2008-09. This effort necessarilyinvolvesapproximationsand judgmentcallsabout an uncertain future. There canbe legitimate differences about how theprojectionsweremade.However, it is crucialto fully articulate, in numericaldetail, theoutcomeswhich areexpectedto comeaboutif present trends continue. The baselineprojectionsare a powerful tool for policyanalysis,evenif they arenotexact.

The principle adoptedby the Task Forcewhen building the baselineprojectionswasto obtain a numericaloutline of the futureassumingthat the four years from 2005-06till 2008-09will proveto besimilar to recentyears in terms of progress on policy andadministration. The baselineprojectionsdonot assumethat major new tax reformswillcomeabout.But they doassumethatthepaceof improvementin policy andadministration,which took place in recent years, wil l bereplicatedbetween2005-06and2008-09. Itis important to not interpret the baselineprojectionsasreflectingfiscaloutcomesif noprogressis made.

Step II . The next stepconsistsof devisingpolicy proposalswhichclosethegaps(if any)identified betweenthe baselineprojectionsandtherequirementsof theAct.

Engagingin policy analysis,andprojections

3

of alternative rates and policies, requiresgrappling with complex questions. TheTask Force utilised an array of empiricallygroundedresearchin choosingbetweenal-ternativepolicies,andmakingprojectionsfortheir potential impactuponfiscal outcomes.This researchharnessedfour datasets: (a)time-seriesof tax revenues,(b) previouslyunpublisheddata about the compositionofexcise revenues,(c) a datasetof roughly 1million recordsof filings for personalincometax, and (d) the CMIE databaseof 2,74,446firms of India. Someof the empirical re-searchwhich was used in this processisshown in AppendixA andB.

Baselineprojections

Deficit projections for 2008-09 under thebaselinescenario(Section3.7), expressedaspercentof GDP, are:

Revenuedeficit 1.66Fiscaldeficit 3.98

Accomplishing the goals of the FRBMrequires finding ways to eliminate thisprojectedrevenuedeficit in 2008-09. Thegap of 1.66 per cent of GDP translatesto Rs.51,540crore in 2004-05. It, hence,constitutes a considerable challenge forpublic finance. At the same time, thereis extensive international experience withthe accomplishmentof much larger fiscalcorrectionsover therequiredtime-period.

Macro perspectiveof fiscal consolidation

Sound proposals for tax and expenditurepolicy require macro thinking about therequired fiscal consolidation (Chapter 4).The broadgoal of macroeconomicpolicy is

to find the mosteffective trajectorythroughwhich theFRBM goalscanbeachieved.

Therearetwo mainquestionsaboutthefiscalcorrectionrequiredby the FRBM: (a) Thequestionof anearly(“front-loaded”)versusalate(“back-loaded”)adjustment,and(b) Thequestionof how adjustmentshouldbesharedbetweentaxationandexpenditure.

Several reasonsindicatethe desirabilityof a‘front-loadedfiscalconsolidation’(i.e. fiscalreformsin 2005-06insteadof later):

• Swift and decisive actions would greatlystrengthen the credibility of the country’seconomicpolicy making.

• India shouldharnesstheopportunitypresentedby the strong economic performance,beingexperiencedin the domesticeconomyand theworld economy, in order to achieve fiscalconsolidationin thisperiod.

• It is possiblethat the macroeconomicoutlookmight be more sombre at some point inthe medium term. In that case, an earlyfiscal consolidationwill createthe fiscal spacethroughwhichgovernmentcanusefiscalpolicyasabalancingtool.

• An early fiscal consolidationwill yield earlyfruits in termsof higher growth in investmentand employment. Theseare desirableresultswhich should be obtained as quickly aspossible.

• Raising tax revenues helps state financesthroughthe devolution of resources,andfuelsGDP growth through bigger resourceflowsinto aspectsof governance,such as law andorder and education,which take place at theState level. An early improvement in thecentralgrossTax/GDPratio will swiftly easethedifficultiesof statefinances,andthusyieldearly benefitsfor the developmentprocessattheStatelevel.

• There is an innate lag betweendecisionsonfiscal reform and their full impact (Section4.3.1).Decisionstaken in2005will fully yieldfruits in termsof higherGDPgrowth andsound

4 Executivesummary

fiscal outcomesby 2006and2007. It is henceimportantto take decisionsearlyaboutreformsin tax andexpenditurepolicies,soasto benefitfrom thefull impactof thesedecisionsby 2008-09.

On the secondquestion,therearea numberof argumentsfavouring fiscal consolidationthrough higher tax revenues rather thanreductionin expenditure:

• Raisingtax revenueshasa powerful side effectof strengtheningStatefinances,while cuttingcentralexpendituredoesnot.

• Cutting expenditurewould be contractionaryfor the macro-economy. Raisingtax revenuesis likely to belesscontractionary.

• Tax reforms have an important side effect -otherthanyielding tax revenues:they alsospurhigher GDP growth by removing the existingdistortionsandmisallocationof resources.

TheTaskForcehenceadoptedfour principlesfor thestrategy for fiscalconsolidation:

I. Fiscalconsolidationshouldberevenue-led.

II. Fiscalconsolidationshouldbefront-loaded.

III. Capital expenditure should be enhanced, tocounter-balancethe contractionaryeffects ofthe fiscal consolidation, but expendituresshouldbeconditionalon institutionalreformtoensurethattheexpenditureis well utilised.

IV. The reforms efforts on revenue expenditureshouldbefurtherintensified.

Strategy for tax reform

The Task Force adopted the followingstrategy for tax reforms(Section5.2).

1. Widening the tax base. India has extensiveexperiencewith thedifficultiesassociatedwithhigh rates,‘exemptionraj’, and pervasive taxavoidance efforts by firms and households.Expandingthe taxbase,ratherthanincreasingrates, is hence the preferredstrategy. This

involvesremoving exemptionsandbroadeningthe scopeof the tax systemto bring withinits fold economicactivities which arepresentlyexempted.

2. Few rates; Low rates. High tax ratesdistorteconomicdecisions and fuel the deploymentof resources into tax avoidance and taxevasion. A large number of rates oftaxes generate problems of bracket creep,classificationdisputes,and political lobbyingabout rates. Theseargumentssuggestthat arational tax systemis onewith very few ratesandlow rates.

It is particularly important to have singlerates in the area of indirect taxes. TheIndian consumeris known to be remarkablysensitiveto apparentlysmallchangesin relativeprices. The goal of a rational tax systemis toempowerhouseholdsto engagein undistorteddecision making, driven by their own needsandpreferences,andnot decisionsmadein theMinistry of Finance.

3. Enhancingequityof the taxsystem. Reformofthe taxsystemshouldfurtherbothverticalandhorizontalequity.

4. Shiftto non-distortionaryconsumptiontaxestoincreaseefficiencyin production and enhanceinternational competitivenessof Indian goodsand services. A key idea of sound publicfinance is to shift the incidenceof taxationupon consumption. Tariffs, excises andturnover taxeson domesticgoodsandserviceshave cascadingeffects. The destination-basedVAT on all goods and services is the bestmethodof eliminating distortionsand taxingconsumption.Underthis structure,all differentstagesof production and distribution can beinterpretedasa meretax pass-through,andthetax ‘sticks’ onfinal domesticconsumption.

5. Enhancingtheneutrality betweenpresentcon-sumptionand future consumption.At present,the tax systemis neutral betweenconsump-tion andsavings. Consumerstypically favourpresentconsumptionover future consumption.Hence, neutrality betweenconsumptionandsavings tendsto depresssavings ratesand in-vestment. Tax reform should impart inter-

5

temporalneutralityin consumption.

6. Enhancing neutrality of the tax system tothe form of organisation. Teamsor groupsof individuals can be organised in manydifferent organisational structures, such aslimited liability companies,associations,clubs,partnerships,limited liability partnerships,etc.The choiceof organisationalstructureadoptedby decision makers in the economyshouldbedrivenby efficiency considerationsandnot taxconsiderations.

7. Enhancing the neutrality of the tax systemto sources of finance. The choice betweendebt and equity and betweenretention anddistributionof profitsshouldnotbedistortedbytaxconsiderations.

8. Establishingan effectiveand efficient compli-ancesystem.Goodtax policy cannotexist with-outgoodtaxadministration.Awell executedtaxadministrationwill enhancetransparency andintegrity, therebyinspiring public confidence.This involves fourelements:

• Establishinga programfor taxpayerser-vice andeducationto promotevoluntarycompliancewith taxobligations;

• Making non-compliancerisky for viola-tors;

• Simplifying compliance procedurestoreducetransactioncosts;

• Using informationtechnologyandmod-ernprocessengineering,capable of pro-viding accurate,timely andsufficient in-formation.

9. Focus on buoyancy rather than immediatesourcesof tax revenue.

Tax revenues can always be increasedbyimposing ad-hoc taxes. For example, it isalways possible to pick sectors with easyenforceability- suchas telecomor bankingoroil - and impose taxes on them. However,suchanapproachis not a long-termfoundationfor a sound tax system. Such ad-hoc taxeshave beenseento inducedeeperdistortionsintheeconomy, adverselyaffectingthegrowth ofGDP throughmisallocationof resources,and

settingthestagefor new kindsof taxavoidancemechanisms.

The reforms strategy of this report focusesonestablishinganeconomicallyefficient,effectiveand equitabletax systemwhich will facilitatevoluntarycompliance.Thefocus inthis reportis on raising tax revenuesthroughhigherGDPgrowth andincreased tax buoyancy ratherthenadhocdistortionarytaxes.

Proposal: The Goods and Services Tax

(GST)

Theexisting framework of taxationof goodsandservicesmaybesummarisedasfollows.Thecentralgovernmentleviestaxongoodsatthemanufacturinglevel while theStateslevytax on goodsat the point of sale. Taxationof serviceson a limited scalebegan in 1994only by the central government. The taxon goods and servicesby the Centre hasgraduallyshiftedtowardsaVAT-typeregime,while taxationof goodsat theState level hasnot.

The problemswith the existing taxation ofgoodsand servicesmay be summarisedasfollows. Thetax baseis fragmentedbetweenthe CentreandStates.Serviceswhich makeup half of GDP arenot taxed appropriately.In many situations,theexisting tax structurehas cascadingeffects, where moving to afull VAT systemhas not yet taken place.These difficulties have led to substantialdistortions,where the tax revenuesfrom afew sectors are disproportionate,and thechoiceof productiontechnologiesandinputsin the country has becomedistorted. Theexisting flaws in tax policy have inducedamalfunctioningtaxadministration.

Theseproblemshave manifestedthemselvesin terms of a poor buoyancy of excisecollections,which hasled to a low Tax/GDP

6 Executivesummary

ratio. Moreimportantly, thishasbeenafactorleadingto slow growth of themanufacturingsector, andemployment,in thecountry.

Theconstitutionaldifficultiesassociatedwiththe taxationof serviceshave beenaddressedby the 88th amendmentto the Constitution,which waspassedin 2003.Traditionally, theCentrehadpowersto tax themanufacturingof goods. The 88th amendmenthascarriedthese powers forward to extend to allservices,includingtheservicesof tradingandretailing of goods. This amendmentenablesParliamentto formulate, bylaw, principlesfor (a) determiningthemodalitiesof levyingtheservicetaxby thecentralgovernment,(b)collectionof the proceedsby the centreandthe states,and (c) sharingof the proceedsbetweenthecentreandthestates.

As a consequence, fiscal planning for theCentrenow innatelyinvolvesdecisionsaboutthe manner of sharing of the proceedsbetweenthecentreandthestates.Analysingpotential future tax revenuesfrom serviceshasto beaccompaniedby planninghow thosetax revenueswill besharedwith thestates.

Themajorproposalof theTaskForceis thattheVAT principleshouldbecomprehensivelyused to tax the consumptionof almost allgoods and services in the economy (seeSection5.3). Thereis a needfor the Centreand the Statesto cometo an agreementonthis fundamentalissue.

The Task Force proposesa ‘grand bargain’whereby States will have the power totax all services concurrently with theCentre.Consequently, bothcentralandstategovernmentwould exercise concurrentbutindependentjurisdiction over common oralmostcommontax basesextendingover allgoodsandservices,andin bothcases,goingupto the final consumer. At the sametime,

both CentreandStateswould be required–undertheproposedgrandbargain – to abideby thefollowing principles:

1. The number of tax rates is proposed to berestrictedto threead valoremrates,in additionto thezerorate.Theproposedratestructureis:

(Percent)Centre State

Floor 6 4Standard 12 8Higher 20 14

Under this proposal, the total tax burden onmost goods– by Centreand States– wouldwork out to 20 per cent. This comparesfavourablywith thestandard VAT ratesseeninOECDcountries.

Thestandardcentralrateof 12 percent,whichis proposedhere, is lower than the existingstandardCENVAT rate of 16 per cent. Thisreductionis madepossiblein a revenue-neutralwayowing to thebroadeningof the taxbase.

2. CentreandStatesshouldagreeonacommonal-ity of exemptionlists andthresholdlimits, andcommonlists for the levy of excise on goodswith negative externalitiessuchaspetroleum.

3. The treatmentof imports and exports shouldbe fully integratedwith this dual-GSTsystem,where imports are charged a two-part levyrepresentingthe Central GST and the StateGST.

4. The GST systemshouldminimisethe costsofcompliancefacedby thefirms of India. Hence,the centreand statesshouldsynchronisetheiradministrativeproceduresandIT infrastructure.Thiswill alsohelpfacilitatetheimplementationof StateVAT within existingdeadlines.

5. In order to handle calculations and fundstransfers to States, there is a need of anationwide clearinghousemechanism. Thecomputation of the final liability shouldbe based on the invoice credit method,whereby credit would be allowed for taxpaid on all intermediategoods or serviceson the basis of the invoice issued by thesupplier. The Centre and the Statesshould

7

cooperatein establishingthis clearinghousein order to transferfunds accurately, withoutincurring complex administrative overheadsorcompliancecosts.

6. The introduction of the GST at both Centraland State levels should be accompaniedbythe withdrawal of all cascadingtaxes suchas Octroi, CentralSalesTax, statelevel salestaxes,Entry tax,Stampduties,Telecomlicensefees, turnover taxes, tax on consumptionorsale of electricity, taxes on transportationofgoods and passangers,etc. This removalof inefficient and distortionary taxes wouldconstitute a major milestone for reforms inIndianpublic finance.

7. The Central Excise Act and the taxation ofservicesby the FinanceAct, 1994, will besubsumedunderthecentralgoodsandservicestax. This should be implementedthrougha legislation which may be named IndianGoodsand ServicesAct. The Stateswill needto simultaneously introduce correspondinglegislation for taxation of goodsand serviceswhich will subsumetheir existing State-levelcascadingtaxes.

Under this proposed‘grand bargain’, theStates obtainrevenues from taxation ofservices,andfrom accessto GSTonimports.More importantly, Indiawouldobtainthefullefficienciesof a single nationalVAT, whileretaininga federalstructure.

This proposalwould constitutea majormile-stonefor the modernisationof India’s indi-rect tax system.Detailedempiricalanalysisobtainedby theTaskForce(AppendixB) hasrevealedthatthisis likely to leadto additionalgrosstaxrevenuesfromtaxationof goodsandservicesof 2 percentagepoints of GDP in2008-09.Of this,roughly0.6percentof GDPwould be transferredto theStates,assumingexisting formulasfor resource sharing.Thisincreasein theTax/GDPratio is centralto theplanproposedin this reportfor achieving theFRBM targets.

From 1986 onwards, indirect tax policy inIndia has been steadily progressingin thedirectionof theVAT principle. Theproposalin the Budget Speechof 7 July 2004, tointegrate the service tax with CENVAT interms of tax credits on input purchases,isan important milestoneon the path to asinglenationalVAT. TheTaskForceseestheintroductionof the GST, as outlined above,asthelogicalculminationof this twenty-yearprocessof debateandpolicy making.

Proposalson customsduties

There is now a wide consensuson thedirectionof customsreformsin India, with adesireto reachASEAN ratesof customs,andto have theminimal ratedispersion.Towardsthis, the Task Force proposesa shift to athree-ratestructureconsistingof 5 per cent,8 percentand10percent.

This will innately involve a certain lossof tax revenue. This loss has beenfully integratedinto the medium-termfiscalplanning framework adoptedby the TaskForce.

Proposalson personalincometax

Reformson personalincometax have beendebatedin India for over a decade. Thereis a broad consensusabout the need toremove exemptions,rationaliseincentivesforsavings,andto broad-basetaxbrackets.

Towards this goal, the Task Force recom-mendsapackagecomprising:

• Removal of exemptionsincluding thoseavail-ableunderSections10A, 10B, 80IA and80IBof the Income Tax Act. However, exemptionsrelating to housingloans,and thoseavailable

8 Executivesummary

to seniorcitizensand womenwill remainun-changed.

• Eliminationof thestandarddeduction availableto salariedtaxpayers.

• Rationalising the savings incentives into asingle ‘EET’ system, where contributionsand accumulationsare tax exempt, but thewithdrawals are taxed as ordinary income.Savings of upto Rs.100,000a year would beeligible for this deduction. Consequently, taxconcessionssuchas thoseunderSection80Lfor interestincomeshouldbeabolished.

• While theabove proposalsinvolve theremovalof existing specialclauses,all existing invest-mentsunderschemeslike PPFwould be fully‘grandfathered’. That is, intereston existingdepositsin theseschemeswould contineto betax-exempt. However, new investmentswouldbepartof theEETsystem.

• A shift to thefollowing two-rateschedule:

Incomelevel Marginal(Rupees) rateBelow 100,000 0100,001– 400,000 20Above400,000 30

A detailed empirical analysis of nearly1,000,000taxpayershas revealed that theabove proposals- asa package- yield lowereffective averagetax ratesfor all categoriresof taxpayers.At thesametime,theproposalsconstitutea long-overduerationalisationofpersonal income tax. Compliance costswould come down; higher tax buoyancywould be obtained;equity will be enhancedand the economywill benefit from reducedtax-distortions.

Detailedeffortsin projectingtheimplicationsof this reformsuggestthatthesechanges- asa package- will leadto a lossof revenueatexisting levels of compliance.However, theTask Force hasuseda variety of empiricalresearchwhich suggeststhat thesereformswill improve tax compliance,which would

overcomethis lossof revenue.

The report also has detailed proposalsonmodernisingthe taxtreatmentof fund man-agement,zero couponbonds,and ‘specula-tive’ transactionsonfinancialderivatives.

Proposalson corporate incometax

The broadcontoursof reform on corporateincometax have beenextensively debatedinthe last decade. The three main issuesinreform are as follows. Depreciationratesneedto be brought into alignmentwith thelow inflation rates and low interest rateswhich now prevail in India. Thestructureofexemptionsneedsto be removed in the lightof thereductionin tax ratesover thelast twodecades.Finally, the gap betweenthe peakratefor personalincometaxandthecorporatetax rateneedsto beremoved.

Reflectingthisconsensus,theTaskForcehasproposedtwo alternative packages,eachofwhich is revenuepositive. Thefirst candidatepackagecomprises:

1. All existingtaxincentivesto be‘grandfathered’for existingunits,but removedfor new units.

2. A reduction in the generaldepreciationratefrom 25percentto 15percent.

3. A reduction in the corporate tax rate from35.875 per cent to 30 per cent for domesticcompanies.

The second candidatepackagediffers fromthe above in two major respects. It isproposedto eliminatethe taxon distributionof dividends, while preservingexemptionfrom incometax of dividendsin the handsof the recipient. It is proposedto phaseoutincentivesoveraperiodof two years,insteadof grandfatheringthem.

9

Proposalson tax administration

The Task Forcehastwo major proposalsonstrengtheningtaxadministration.

Thefirst concernsthe implementationof theGST systemoutlined above. The efficientimplementationof a systemof tax credits,and refund of GST embeddedin exports,requires a sound IT system. The issuesfaced in the GST system are identical tothoseencounteredin thehandlingof TDS inincometax administration.Hence,the TaskForcerecommendsthat theexisting TIN andOLTASsystems,developedbyCBDT, shouldbe usedfor the implementationof the GST,bothat theCentreandatStates.

Thesecondmajorissueconcernstaxevasion.A fresh effort needs to be undertakenin ‘risk-based assessment’, in order toidentify tax evaders while simultaneouslyhaving a taxpayerfriendly system. Honesttaxpayersshould notsuffer from suspicionand harassment. At the same time,elementarynotions of justice require thatwrongdoersareidentifiedandtax evasionispenalised.The TaskForcehasproposedanIT-intensive systemnamedRisk IntelligenceNetwork (RIN) which would addressthesegoals. This will be aneffective instrumentagainsttaxevaders.

Expenditure reforms

The Ministry of Financeplays a supportingrole on issuesof expenditure. The bulk ofexpendituretakesplacein variousMinistrieswith oversightof the PlanningCommission.Hence,the proposalsof the Task Force onexpenditure reforms are essentially in thenature of a policy approach, and wouldrequire furtherdiscussionwith the Planning

Commission,administrative Ministries andother stakeholders, to work out a sharedprogramfor expenditurereforms.

Government expenditurescan play a pro-found role in thedevelopmentprocesswhenthey producepublic goods,suchasdefenceor law & order, where the consumptionofthepublic good byanincrementalcitizenin-troducesno costs,and it is not possibletoexcludeany citizenfrom benefitingfrom thepublicgoods.Somequasi-publicgoods,suchasprimaryhealthandeducationservices,arealsowell recognisedasbeing the legitimatefunctionof government.

The broadstrategy for expenditurereformsmay be summarisedas comprisingof fourelements:

I. Public goodsversussubsidies A greaterportionof expenditureneedsto be devotedto legitimatepublic goods, as opposed to transfers andsubsidies. The plan versus non-plan or thecapitalversusrevenueclassificationsneedto bere-examinedin this light.

II. Central versuslocal public goods In the spiritof the 74th amendment,resourcesthat areused for the production of local publicgoods,suchas water, sanitation,and primaryeducation,shouldbe transferredto PanchayatiRaj institutions,who have better incentivestospendeffectively, and have better knowledgeabout local preferences,local problems,andalternativeproductiontechnologies.

III. Focuson public goodsoutcomes The publicfinance system in India has traditionallyfocusedon expenditure. Thereis a needfor agreaterfocusonpublicgoodsoutcomes.

IV. Impr ovementsin institutional mechanismsThe provision of public goods can often beachieved more effectively through the useof the private sectorin production. The roleof public-private partnershipsneeds to beextendedinto abroaderrangeof publicgoods.

Theseissuesaresketchedin greaterdetail in

10 Executivesummary

Section5.9.

Projectionsfor the reforms scenario

Chapter6 shows projectionsfor outcomesthat would obtain if the above reforms arecarried out. Thesecan be comparedandcontrastedwith the outcomesthat flow fromtraditionalratesof progress,i.e. the‘baselinescenario’,shown in Chapter3.

Thereformsscenariosuccessfullydeliversonall the requirementsof the FRBM Act. In2008-09,a revenuesurplusof 0.15 per centis projected.The fiscal deficit in 2008-09 isprojectedat2.80percentof GDP.

The fraction of revenuereceiptswhich areusedup to merely pay interest is a majorindicator of fiscal stress. That ratio isprojectedto be much lower in 2008-09,at31.69percentunderthereformsscenario,ascompared with the value of 41.48 per centunderthe baselinescenario.This portraysasharpalleviationof fiscalstress.

The non-interestexpenditureof governmentcan be used for developmental purposes.Under the baselinescenario,it is projectedto drop to 9.83 per cent of GDP by 2008-09. Under the reformsscenario,a value of10.76 per cent of GDP is obtained,whichgivesthe governmentmuchgreaterspacetogiveanadditionalimpetusto developmentbyspendingon the provision of public goods,suchaslaw andorder, judiciary, health,andeducation.

Transfers to states– states’ share of netproceedsof taxes and duties, and non-plan transfersto states– are projected tostagnateat 3.3 per cent of GDP underthe baselinescenario. Under the reformsscenario,they are projectedto sharply go

up to 4.4 per cent of GDP in 2008-09. In 2008-09,this projectedincrementalresourceflow, of Rs.58,340crore, wouldserve to greatly alleviate the fiscal stressin State governments. Along with largerplan expenditurefor States,it is likely tobolsterexpenditureson public goodswhichare produced at the State level, such aslaw and order, judiciary, education, andhealth. State financeswould also benefitby the major expansionof their tax base,under the proposals of this report, andby closely dovetailing StateVAT with thearchitecturefor implementationof theGoodsand ServicesTax that is proposedin thisreport.

Impact

The fiscal reforms proposedin this reportwouldhaveenormouslypositive implicationsfor India’s outlook, going well beyond thenarrow issueof achieving targetsspecifiedintheFRBM Act and associatedrules.

A world class tax system. Implementationof the reformsproposedin this reportwouldgive India a world-classtax system. Thiswouldreducecostsof compliance,reducetaxevasion, and largely eliminate the distortedbehaviour that comesfrom tax avoidance.The long-standingdistortion of differentialtreatment of manufacturing and serviceswouldberemoved.Thereformswill enhanceequity, since small firms and middle-classhouseholdsbear the brunt of compliancecostsandhigh tax rates.

Impact on investment. Public capitalexpenditureis projectedto be higherby 0.6percentof GDPin 2008-09,whencomparedwith the baselinescenario. This differenceis a substantialsum,which is roughly twice

11

the annual expenditure on NHDP. Privateinvestmentis also likely to go up, owing toimprovementsin taxpolicy, andtheimprovedprovisionof publicgoods.

Impact on health and education. The bulkof expenditureon healthandeducationtakesplaceat the level of Stategovernments.Asarguedabove, thereportproposessubstantialaddition of resourceflows to States. Apartfrom Statefinances,the secondsourceforresourcesinto healthand educationis Planexpenditure. Plan expenditureis projectedto be higher by roughly Rs.20,000crore in2008-09underthereformsscenario.

Impact on manufacturing. The manufac-turing sectoris a potentialsourceof croresof jobs in coming years. The central VATon manufacturing is proposedto go downfrom 16 per cent to 12 per cent. The ef-fective reduction of the burden on manu-facturing will be greater, since they wouldalso get taxcredits for a full rangeof ser-vicesconsumedby them.Manufacturerswillbenefit from the full refund of the GoodsandServicesTax embeddedin their exports.SituationswhereIndian firms facenegativerates of protection, with low customsdu-ties, would be eliminatedby the proposedreforms. The peak income tax on manu-facturing firms would be lower. All theseproposedreformswould bolstermanufactur-ing andemployment-intensive growth in thecountry.

Impact on exports. Indirect taxes inIndia have thus far beenunfriendly to thecentralfeatureof globalexportstoday, whereproductionis broken down into specialisedsteps taking place at dispersedlocationsspread across the world. The reformsproposedin thisreportmeanthatIndiawouldbe at par with Chinain termsof the indirect

tax framework, with a systemconsistingoflow customsduties,a nationwideGoodsandServicesTax,andafull refundof theGSTonall exports(seeFigure7.1). Theintroductionof this systemin Chinain 1994presagedthegreat boom in manufacturing exports fromChina,andwill helpdosimilarly in India.

The existing biasesagainst export-orientedsmall and medium enterprises will bereversed by the proposed reforms (seeSection7.4). This will leadto a blossomingof agro-relatedand manufacturing exportsfrom thecountry, which will generatea largenumberof jobs.

Impact on financial sector. The proposedtax reformsof this reportreducetheaveragetax paid by financecompanies. The EETtax system proposed in this report setsthe stage for an enormousexpansion ofprofessionalfund management.This will beassistedby theclarificationsproposedin thisreport for the tax treatmentof outsourcedfund managementof all kinds. Finally,the report proposesto modernisethe taxtreatmentof derivatives transactions,whichhasbeena major hindrancefor the growthof sophisticatedrisk managementin thecountry.

Impacton Statefinances. Stategovernmentsarecrucialto governanceanddevelopmentinthe country. Statefinancewould obtain anenormousboost,underthe proposalsof thisreport,throughfour channels:

1. Theincreasein Centralgrosstax revenues– ofroughly 3 percentagepoints of GDP – wouldinnatelyincreaseresourcetransfersto theStatesof roughly1 percentof GDP.

2. Stateswould benefitby theproposedextensionof servicesastheir taxbase.

3. Stateswould benefitby the proposedimposi-tion of StateVAT on imports,which would ac-

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crueto them.

4. Higherplanexpenditurewill beassociatedwithlarger resourceflows to Statesthrough statesandUT plans.

Thesebenefitsare,however, apartof a‘grandbargain’ betweentheCentreandtheStates,asoutlinedabove, which doesrequireStatestocoordinatetheir fiscal reformswith this shiftto theGST.

Impact on defenceexpenditure. Under thebaseline scenario, defence expenditure isexpectedto steadilydrop from 2.4 per centof GDP in 2001-02to 1.9 per centof GDPin 2008-09. The reforms proposedin thisreporthalt this decline,andstabilisedefenceexpenditureat2.3percentof GDP.

Reducedcrowding out. Under the reformsproposedin this report, the fiscal deficit in2008-09would besmallerby 1.2 percentagepoints when comparedwith the baselinescenario.This constitutesa reductionof theresourcepre-emptionby Government.

Impacton prices. Theshift from theexistingframework of indirect taxes to the GST,coupledwith the reductionin import tariffs,is expectedto have asmallone-timenegativeeffectonthepricesof goods,andasmallone-time positive effect on the pricesof services(seeSection7.8).

Impact on growth and employment

All these envisioned implications of thereformsproposalsof this reportaddup to ascenariowhereIndia is likely to experiencea considerableaccelerationin GDP growth,and deliver high quality growth. This willobviously also require associatedreformsin other aspectsof the economy to beundertakenat thesametime.

The threemajor elementswhich will play arole, from afiscalperspective,are:

• The first major factor is the improved gover-nancemadepossible by easingthe fiscal pres-suresupon government.Thiseasingof resourceconstraintswill greatlyimprove thequalityandquantityof publicgoodsandquasipublicgoodsthat areprovided. The growth implicationsofimproved public goods,suchas the NHDP, islikely to beconsiderable.

• The second element lies in removing tax-induced distortions. The existing fiscalsystemhasled to large-scalemisallocationofresources. Tax reforms in India are likelyto be expansionarythrough their impact onproductivity. The behaviour of individualsand firms in India is greatly distortedby taxcompulsions.In a simple,rationaltax system,individualsandfirmswill makedecisionsbasedon economicprinciples,andconsiderationsofefficiency and productivity, insteadof beingdrivenby taxplanning.

• Thethird major factoris the issueof crowdingout, i.e. the pre-emptionof financial savingsby the government. Tax reforms will freeup greater resources for both equity anddebt investment in the country. The fiscalconsolidationwill inspire confidencein theoutlook for India, in theeyesof bothdomesticandforeigninvestors.

In particular, the taxreformsproposed inthisreport will lower the cost of equity capital,and encourageentrepreneurship. They areconsistent with a vision of investment-ledgrowth for thecomingfiveyears.

It is projectedthat GDP growth would befasterunderthe reformsscenario,reversingthe slow reduction in GDP growth thatis expected to take place in the baselinescenario. In the terminal year alone, GDPis projectedto be higher under the reformsscenarioby Rs.1,42,000crore. This wouldtranslateto significantlyhigherincomesandemployment. Assuminga 60%labourshare,an incremental Rs.85,200 crore of wage

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incomewould be injectedinto the economyin the year 2008-09 if fiscal reforms aretakenup, which would impacton wagesandemployment.

Thereis aninnatesynergy betweenaccelera-tion of GDPgrowth andfiscalconsolidation,sincetaxesonabaseof higherGDParemoreeasilyableto pay off the existing debt. Thegoal of the reformsproposedin this reportis to help harnessa virtuouscycle of higherGDP growth, fiscal consolidationand fiscalreform,eachof whichstrengthenstheother.

On 8 July, the Finance Minister’s budgetspeecheloquentlysaid:

It is in our hands to shape our

destiny. Progress is not always on

a linear path, nor is it inevitable.

If we bring thought and passion to

our governance, and walk the path of

honour and courage, we can make the

future happen. And this century will

be India’s century.

The reformsproposedin this report are notderived from linearandincrementalchangeson pasttrends. Their implementationis notinevitable,andwill requiresustainedthoughtand passion on the part of Parliamentandcivil society. It is the deeply held viewof the Task Force that their implementationwill reshapeour destiny, andtake India to acommandingpositionin theworld economy.

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