In black and white, tax raids are no solution

The window for the amnesty scheme for the disclosure of black money has closed at the end of September. We may expect a further increase in the number of tax raids now. This comes on top of the threefold increase that has already taken place before the government announced the amnesty scheme. The Central Board of Direct Taxes has directed the tax department to use a provision under Section 276C (2) of the Income Tax Act that allows the department to make rigorous imprisonment for tax defaulters. Further, payments made in cash for buying goods worth more than Rs 2 lakh have started attracting one per cent tax collected at source from June 1. These measures taken by the Government to clean up the large amount of black money circulating in the economy are wholly welcome.

Black money is a tax on the honest. The corrupt avoid paying taxes while the honest have to pay. Large numbers of studies show that some degree of coercion is necessary to improve tax compliance. A study from Israel found that letters sent to taxpayers warning of coercive action led to improvement in tax compliance. Moral persuasion, however, was not productive. Taxpayers showed an increase rather than a decrease in tax deductions. A study from Bangladesh concluded that coercion or persuasion are less likely to improve tax compliance when used separately than when used in combination, although coercion seems the more powerful of the two. The Government is on the right track in initiating coercive measures to clean up the scourge of black money from the economy.

The result of this cleanup will be an increase in the effective rate of tax. Say, today a business sells one-half of the goods in white and the other one-half in black. It pays, say, a tax of 30 percent on the goods sold in white; and pays no tax on the goods sold in black. The effective rate of tax on the business then reduces to 15 percent. The businesses will have to pay a tax of 30 percent on the entire transaction after sales in black come to an end. The effective rate of tax paid will increase from 15 percent to 30 percent. Thus, the drive to clean up the black money hides within it a hidden objective of increasing the effective rate of tax. Here there is trouble.

The rate of tax in India is already high. Economist Parthasarathi Shome has shown that the non-poor in China paid 18.9 percent of their incomes as taxes in 2005, against 19.7 percent by the non-poor in India. Indians will have to pay yet higher taxes if the government cleans up the black money.  Such an increase in the effective tax rate is not justified.

The Manu Smriti says, “As the sun with its beams takes (to itself) the water during eight months, so let (the king) ever take from his realm the revenue…” The fourth Caliph Ali ibn Abi Talib wrote, “If the tax-payers complain to you of the heavy incidence to taxation… then reduce their taxes… Decrease in state income due to such reasons should not depress you because the best investment for a ruler is to help his subjects at the time of their difficulties. They are the real wealth of a country and any investment on them even in the form of reduction of the tax burden will return to the State in the shape of the… improvement of the country at large. At the same time you will be in a position to command and secure their love… along with the revenues.”

The second problem is that an increase in the effective rate of tax will render large numbers of small businesses unviable. A Kanpur-based Chartered Accountant said that liquidity has disappeared from the market in view of the steps taken to eradicate black money. This means that businesses are not able to bear the burden of 30 percent rate of tax applicable on hundred percent white transactions. Businesses are clamming up and shelving their investment plans. Businesspersons are spending more energies thinking of ways to avoid the taxman rather than of ways to make more investments.

The third problem is that an increase in the rate of tax coupled with more coercion has two contradictory impacts. The increase in rate of tax will push the businesspersons towards more transactions in black, while coercion will push them towards more transactions in white. The result will depend upon the effectiveness of the coercive mechanism. The Government earlier adopted the policy of coercion to stop gold smuggling. It failed. Ultimately, the Government had to reduce the rate of import tax on gold. In a country as big as India and a corrupt bureaucracy, it is quite possible that the present drive will lead to an increase in black money, rather than its decrease.

The fourth problem is that the government is using the revenue mainly for consumption. The Government is paying increased salaries and pensions to the government servants. The increased revenue is being increased not to improve infrastructure or to eradicate poverty but to pamper the government servants who are already tyrannising the taxpayers by recovering ‘hafta’, for example. The present government lacks the moral authority to collect more taxes unlike Maharana Pratap who took money from Bhamashah for waging a war.

A simultaneous reduction in tax rates is, therefore, necessary while cleaning up the black economy. Such reduction will solve the first three of the problems — the effective rate of tax will not increase, small businesses will not go out of business, and there will not be an increase in black money to escape from the high rates of effective tax. The fourth problem requires that the Government use the money for infrastructure rather than increased consumption by the government servants. In conclusion, the drive to eliminate black money will work only if accompanied with a reduction in the tax rates and a transparent use of the tax revenues for infrastructure development. It will be counterproductive in its present form.

We should not compare the tax rates in India with those prevalent in the developed countries because those countries make monopoly incomes on the back of advanced technologies and do not face competition from other countries. Increase in the rate of tax in India will place Indian businesses at a disadvantage against the businesspersons, say, in Bangladesh.

Author was formerly Professor of Economics at IIM Bengaluru

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