7.2. Changes in Indian Taxation System

Developing countries have embarked on tax reforms in recent years. Such reforms were motivated both by local factors as well as by rapid internationalization of economic activities. The need to correct fiscal imbalances and the transition from a centralized plan to a market economy were the important local factors hastening tax reforms. Difficulties in compressing expenditures necessitated that tax system reform take an important role in fiscal adjustment strategy.

The transition from plan to market required the substitution of administered prices with market determined prices, the replacement of physical controls with financial controls, and the substitution of public enterprise profits with tax revenues. Likewise, tax reforms become imperative in a globalizing environment. Enhancing competitiveness and attracting foreign investment require minimizing both efficiency and compliance costs of the tax system. Globalization also involves loss of revenue from customs, which needs to be replaced with domestic taxes.

The Indian tax system too had to be reformed in response to changes in development strategy. In the initial years, tax policy was used as an instrument to achieve a variety of diverse goals which included increasing the level of saving and correcting for inequalities arising from a market structure created by a centralized planning regime, including a licensing system, exchange control, and administered prices.

The evolution of tax policy within the framework of planned development strategy had important implications for India:

1. Tax policy was directed to raise resources for the public sector without regard to efficiency implications.

2. The objective of achieving a socialistic pattern of society on the one hand and the attempt to tax large oligopolistic rents generated by the system of licenses, quotas, and restrictions on the other, called for a steeply progressive tax structure.

3. Pursuit of a multiplicity of objectives complicated the tax system with adverse effects on both efficiency and horizontal equity. This also opened up large avenues for evasion and avoidance of taxes.

4. The above considerations complicated the tax system, and selectivity and discretion became a legitimate part of the tax policy and administration.

5. The influence of special interest groups, changing priorities, and lack of information system and scientific analysis led to ad hoc and often inconsistent calibration of policies.

While India has had a history of periodically assessing the tax structure, through the constitution of tax reform committees (India 1971, 1977), actual reform attempts were largely ad hoc. It required a crisis of some severity before systematic tax reforms were implemented. Fiscal and balance of payments crises of 1991 warranted systematic reform not only to improve the revenue productivity of the tax system to phase out fiscal imbalance, but also to reorient the tax system to the requirements of a market economy.

The Tax Reforms Committee (India 1991) laid out a framework and a roadmap for the reform of direct and indirect taxes as a part of the structural reform process. The important proposals put forward by the TRC included:

1. Reduction in the rates of all major taxes, i.e., customs, individual, and corporate income and excise taxes to reasonable levels, maintain progressivity but not such as to induce evasion.

2. A number of measures to broaden the base of all the taxes by minimizing exemptions and concessions, drastic simplification of laws and procedures, building a proper information system and computerization of tax returns, and revamping and modernization of administrative and enforcement machinery.

3. It also recommended that the taxes on domestic production should be fully converted into a value added tax, and it should be extended to the wholesale level, in agreement with the States, with additional revenues beyond post-manufacturing stage passed on to the State governments.