The IMF prescribed severe austerity and economic shrinkThey loved Indira Gandhi’s garibi hatao socialism in the 1970s, which raised the peak income tax rate to 97.75%, along with a stiff wealth tax. At one post-budget press conference, I asked what was the maximum a rich person could earn after honestly paying taxes. An official replied that, assuming a rich person’s assets yielded 7% (which at the time was the yield on national savings certificates), then the maximum he could earn after taxes, no matter how great his assets, was just Rs 25,000 a year! In theory, this should have ushered in a socialist paradise. In practice, it converted India into a massive black economy. Businessmen faced the choice of honestly going bankrupt or dishonestly concealing income. No prizes for guessing which path they chose. Actual collections of income and corporate tax in 1970-71 totalled Rs 780 crore, just 1.8% of GDP. Economic liberalisation cut the top income tax rate in stages from 56% in 1991 to 30% in 1997. Leftists said this was enriching the rich. Actually, the rich started paying much more. Payments of direct taxes rose sharply, from 2.4% of GDP in 1990-91 to 3.6% in 2000-01. But even this paled before the huge upsurge after 2004. For 2007-08, the budget projected income and corporate tax of 6.2% of GDP. Actual collections have exceeded expectations so far, and the final figure may be a whopping Rs 300,000 crore, or 7% of GDP. So, the rich have flooded the government’s coffers as never before. Few countries in history have experienced such a huge upsurge. What accounts for it? Lower tax rates are only part of the story. Obviously people are more willing to pay taxes at lower than higher rates. But, as our table shows, lower tax rates in the 1990s yielded good improvements, but not the bonanza of the last few years. Indeed, the recent imposition of a surcharge and cess means that the peak rate of income tax has actually risen, from 30% in 1997 to almost 34% today. Yet, tax collections have skyrocketed. So, lower tax rates after 1990 are only a small part of the story. A bigger part of the story is the abolition of wealth tax on shares in 1993. During the garibi hatao days, a company that declared good profits raised its share price, and hence raised the wealth tax that its promoter had to pay. Extortionate income tax rates made savings from white money impossible. So, promoters had to sell their shares to pay wealth tax. They were doomed to extinction if they kept profits on the books. Naturally, they found a thousand ways of keeping profits off their books, depressing share prices and their wealth tax liability. The abolition of wealth tax on shares in 1992-93 attracted little public attention since actual collections of wealth tax were small. Yet, this single measure suddenly made it possible for businessmen to keep profits on the books and improve shareholder value. Keeping profits on the books meant paying more corporate tax, of course, but it also carried the reward of higher share prices, without the penalty of wealth tax. The immediate impact on tax collections was significant but not revolutionary. Many businessmen were reluctant to declare all profits honestly, in case reforms were suddenly reversed (as seemed entirely possible at the time). The tax administration was so weak and corrupt that tax evasion carried little risk. This situation changed with the computerisation of banks and tax records. This led to Tax Information Networking (TIN) after 2001, enabling tax authorities to trace transactions and ask uncomfortable questions. Stronger tax administration made tax evasion more risky, and thus helped improved tax honesty further. The clincher was the boom in the stock markets and IPOs (initial public offers) of shares in the mid-2000s. Companies raised money for expansion by issuing new shares to the investing public at ever-higher prices. The price they could ask was typically a multiple of their profits. So, the higher the profits they showed in their books, the higher was their sale price. For the first time, business honesty became massively profitable. Finally, GDP growth accelerated from 6.2% in the 1990s to 8.7% in the last four years. This yielded a boom in corporate profits and hence corporate taxes. The lessons are clear. Extortionate tax rates hit honesty, not riches. Cutting tax rates by itself will not produce honesty: you need a stick (the TIN system) as well as carrots (lower tax rates). Finally, you need a booming stock market to convert tax honesty into a profitable launch-pad for high-priced share sales. This combination has now produced a tax bonanza of 7% of GDP. This is not soaking the rich. Rather, it is a system where the rich have the right incentives to share their prosperity with the tax authorities in the hope of getting richer still. Direct tax collections of Rs 300,000 crore can finance massive rural infrastructure, skill development anti-poverty schemes. This will reduce poverty far more than the garibi hatao tactics of the 1970s.
- Roads will lead to rural prosperity
- Regulate the regulators to ensure higher standards