Tax to GDP ratio

Subject: Economy

Section: Fiscal Policy

Context

India’s tax to GDP ratio is higher than proclaimed and it is time to change the quality of expenditure.

Details

Taxes, fiscal deficit, and debt are interrelated —
- lower tax revenue means higher fiscal deficit, for the same level of expenditures, and higher deficit means higher debt.
- Thus all the three have an effect on growth and/or inflation.
Tax to GDP ratio for India
- It is around 10-11 percent of GDP and it has stayed at close to that level for the last 20 years
- In comparison with its peers, India’s Tax to GDP ratio is much lower (Central tax to GDP ratio).
- However according to the World Revenue Longitudinal Data for- 1990-2019:

G20 Countries	Tax to GDP ratio (at all level of government)
India	16.7
China	15.9
Mexico	14.1
Indonesia	11
Saudi Arabia	5.9

Further, tax-GDP ratio adjusted for PPP per capita income–
- Tax gap — the difference between actual and actual adjusted for level of income.

World average tax gap is -1.3 percent
India has a tax gap +1.2 per cent for the nine years 2011-2019. So, India’s tax GDP ratio averages 2.5 percentage points more than an average economy.
However, there is little evidence that a higher tax/GDP ratio helps growth.
- According to one theory-higher taxation would lower the fiscal deficit and increase growth.
  - Triple whammy-if tax rates were lowered, revenues would decline, the fiscal deficit & inequality would increase.
- However, according to another theory (Laffer curve) -higher corporate tax rates stifle investment, increase tax non-compliance, and lower growth.
India’s Experience:
- In september2019 the corporate tax rate was lowered by around 10 percentage points.
- For the three months April-June 2022, corporate tax revenues, y-o-y, increased by 30 per cent.
- Using 2019-20 as a base, corporate tax revenue has increased by 66 per cent, GDP by 33 per cent — an average tax buoyancy of 2.0 over three years.
- Tentatively, the tax-GDP ratio in the fiscal year 2022-23 will average over 18 per cent in India, a level close to Japan and the US.
The Indian economy should thus shift away from simplistic notions of the tax-GDP ratio being low to expenditures and quality of expenditures.

Laffer Curve:

It was introduced by economist Arthur Laffer in 1979.
Laffer Curve is based on the principle that lowering tax rates boost economic growth as it causes increased spending by putting money into the hands of taxpayers.
The Laffer curve showcases the relationship between rates of taxation and the resulting levels of government revenue.
- The underlying principle of the Laffer curve is that tax revenue is increased as the government increases tax rates. However, at very high rates of taxation, practices of tax evasion start, there is low motivation to work, hence if the tax rates are lowered it can boost the revenue.

Tax-to-GDP Ratio

It is a gauge of a nation’s tax revenue relative to the size of its economy as measured by gross domestic product (GDP).
Tax-to-GDP ratio is calculated by dividing the tax revenue of a specific time period by the GDP.
The ratio provides a useful look at a country’s tax revenue because it reveals potential taxation relative to the economy.
It also enables a view of the overall direction of a nation’s tax policy, as well as international comparisons between the tax revenues of different countries.
Developed nations typically have higher tax-to-GDP ratios than developing nations.
A tax-to-GDP ratio of 15% or higher ensures economic growth and, thus, poverty reduction in the long-term, according to the World Bank.