Economic Survey 2018 - Vol. 1, Ch.4: Reconciling Fiscal Federalism & Accountability (Download PDF)

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What is taxation? - Taxation is not just for raising state revenue but can be critically important for economic and political development. Taxation is the economic glue that binds citizens to the state in a necessary two-way relationship.

Direct Taxes and Indirect Taxes

  • Direct taxes are felt more by the taxpayer. Direct taxes feel more like expropriation because they reduce citizens’ disposable income, the earnings that they get to keep.

  • With indirect taxes, citizens are burdened but that sense is leavened to the extent that citizens feel they are exercising choice.

  • Advanced countries collect a substantially higher proportion of their taxes as direct taxes than do emerging markets. This proportion has also risen over time.

  • In the development process, import taxes (an indirect tax) and property taxes (an income tax) were the primary sources of revenue. As time went by, government collections shifted toward income taxes, so that workers could contribute to their social insurance.

  • Europe in the 1970s discovered the value added tax (VAT) as an important source of revenue, which led to a renewed rise in the share of indirect taxes.

  • Today direct taxes account on average for about 70 % of total taxes in Europe.

  • India has the lowest share of direct taxes in total taxes.

  • India’s reliance on direct taxes seems to be declining, a trend that will be intensified if the Goods and Services Tax (GST) proves to be a buoyant source of revenue.

  • 📝 Fiscal decentralization is often embraced as not just a desirable economic but also as a political and philosophical principle, spending and tax decisions must reflect local preferences as far as possible.

  • The graphs below give a view of relation between own revenue and total revenue; direct tax and total revenue.

  • India stands out as a country where the second tier (states) generate a very low share of its revenue from direct taxes: about 6 % in India compared to 19 % in Brazil.

  • Rural local governments’ (RLGs) reliance on own resources is just 6 % compared to 40 % for third-tier governments in Brazil and Germany. Panchayats raise about 4 % of their overall resource envelope in the form of direct taxes, compared with about 19 and 26 % in Brazil and Germany respectively.

  • India’s urban local governments (ULGs) are much closer to international norms. Their own revenues as a share of total revenues are actually higher than Brazil and Germany, while their direct tax share (about 18 % of total revenues) is only marginally lower than Brazil (19%).

Image of source of revenue

Image of Source of Revenue

Image of source of revenue

State and Centre Association Regarding Taxes

  • Resources received by the states as part of successive Finance Commission verdicts are not “devolved” resources but shared resources. The Center is merely collecting the taxes in the divisible pool on behalf of the states, and sharing it with them.

  • The position must be assessed against the following realities:

  • It is difficult to dispel the association (in the eyes of taxpayers) of the Center with the income taxes and customs duties that form a major part of the divisible pool.

  • If the Center were a mere collecting agency the funds would be apportioned according to states’ tax bases; they would not have sizable redistributive component.

Local Governments: What Do We Know?

  • RLGs or panchayats were mandated to have three tiers in states with population of over 20 lakh. The Constitution listed 29 matters which could be the focus of their governance, such as agriculture and land reforms, minor irrigation, small scale industries, rural communication, drinking water, poverty alleviation programmes.

  • States were also supposed to constitute a quinquennial State Finance Commission (SFC) to determine the share of their financial resources going to the local tiers, analogous to the Finance Commissions at the union level.

  • Empowered in such a manner, ULGs and RLGs were mandated to prepare and implement plan (s) for economic development and social justice.

Expenditure Patterns of Different Tiers of Government

Image of Expenditure patterns of different tiers of government

Image of Expenditure Patterns of Different Tiers of Government

Image of Expenditure patterns of different tiers of government

The central and state governments spend on an average 15 - 20 times more per capita than do RLGs. ULGs spend about 3 times more. This gap has persisted over time despite per capita spending by RLGs increasing almost four-fold since 2010 - 11.

Overwhelming Reliance on Devolved Funds

  1. ULGs are different: ULGs seem to be doing much better in terms of own revenue generation. They generate about 44 per cent of their total revenue from own sources. RLGs rely overwhelmingly (about 95%) on devolution.

    Per capita own revenue collected by ULGs is about 3 per cent of the urban per capita income.

  2. Variation across states: There are also vast differences between RLGs within each state.

Broadly, there are two categories:

  1. RLGs of those States that collect some direct taxes and own tax revenue (e. g. Kerala, Andhra Pradesh and Karnataka in our sample).

  2. RLGs of states like Uttar Pradesh that almost entirely depend on transfers. This variation is much starker in case of RLGs than ULGs

  • The overwhelming reliance on devolved funds which, to a large extent, are tied to sectors and schemes.

  • Gram panchayats (GP) spend the bulk of such funds on earmarked areas, such as roads, other basic services, and sanitation and community assets.

  • The better the performance in generating own revenue via taxes, the stronger accountability is expected to be.

Other Issues

  1. In many states, RLGs and ULGs have not been devolved enough taxation powers.

    • Successive Devolution Reports of the Ministry of Panchayati Raj (MoPR) show that the share of revenues assigned to local governments in many states are much less vis-a-vis expenditure assignments.

    • Several states notably Kerala, Maharashtra, Karnataka, Gujarat and West Bengal are consistently improving.

  2. Most states have constituted SFCs, very few seem to have accepted their recommendations in full or even to a significant extent, especially those that carry financial implications for them.

The percent of acceptance of such recommendations varies from as low as 11 % in Karnataka to above 50 % in West Bengal, Andhra Pradesh and Rajasthan to full acceptance in Kerala.

State and Local Governments: Posing an Entirely Different Question

Why is Second and Third Tier Institutions Own Revenue Collection, Especially from Direct Taxes, So Poor?

  • A common answer is that higher levels especially the states have not devolved enough taxation powers to the Panchayats.

  • The property taxes collected at the second and third tiers of government are

  • land tax assessed and collected at the state level

  • building tax, including property/house tax, collected at the municipality (ULG) and gram panchayat (RLG) levels.

  • Property taxes are the principal sources of direct tax revenue at the third tier of government, apart from professional taxes.

  • The collections from these sources of revenue are at very low levels because of archaic base values far below market values applied to properties, low rates of taxes levied, and lack of powers to local bodies in some states like Odisha and Rajasthan.

Land Tax Vis-a-vis Potential: States

  • Different states follow different methodologies to assess land values and apply different rates of land tax.

  • The significant wedge between the market price and the taxable price in Kerala is because the market values of land in the State are much higher than the underlying notional values.

  • The all-India average is boosted by the collections in States like West Bengal and Gujarat which are doing much better in this regard.

  • The stark finding is that the states collect a small fraction of their potential: an all-India average of 19 per cent if unreasonably low land values are assumed, and about 7 per cent on more realistic land value assessments.

House Tax Vis-a-vis Potential: RLGs

  • RLGs are empowered by states to collect taxes on house and commercial properties than land taxes of any kind.

  • The total property tax collection of RLGs—including tax on houses and commercial properties—is set against their house tax potential.

  • As with land taxation, states follow different methodologies to assess value of houses and the land values embedded in a property

  • They also apply different rates of house tax. States such as Kerala apply unit rates of taxes on a given plinth area while states such as Karnataka and West Bengal apply ad valorem rates.

  • Even in states viz. Kerala and Karnataka that are ahead of others in devolution of powers to RLGs, the collection vis-a-vis potential is only around one-third.

Land Tax Vis-a-vis Potential: Center

  • Some Union Territories (UTs) such as NCT of Delhi and Puducherry have their own administrations, which take charge of land tax collection. UTs where the central government assumes this responsibility are Chandigarh, Dadra and Nagar Haveli, Daman and Diu, Lakshadweep, and Andaman and Nicobar Islands.

  • Actual collection in these UTs is, on average, around 30 per cent of potential.

  • The under-collection of direct taxes relative to potential afflicts the Center as much as the other two tiers.

Conclusion: A Low Equilibrium Trap?

  • State and local governments in India (federal tiers 2 and 3) rely much more on devolved resources and much less on their own tax resources and they collect less direct taxes.

  • The reason is not that they don’t have enough taxation power. Rather, that they are not fully utilizing the taxation powers they already possess.

  • 📝 The states are not collecting taxes to their capacity because

  • There is little reason to collect more taxes if they cannot be spent efficiently.

  • Unwillingness to tax by the State, possibly because of proximity between state and citizens.

  • Maybe taxpayers/citizens are able but unwilling to pay more, because they are dissatisfied with the quality of services they are receiving.

  • The status quo can be an equilibrium desired by all actors with higher tiers (both Centre and states) using their devolution powers to control and influence lower levels. This can be a trap.

  • Given the quality of public service delivery, such taxes are often viewed as a “tribute” to a state rather than a contribution to and acknowledgement of the state in raising the quality of life.

  • One consequence is middle-class exit to more privately-provided services (safety, health, and education) that only serves to exacerbate the problem.

- Published/Last Modified on: February 8, 2018

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