Tax Buoyancy and Tax Devolution

What is the issue?

Poor responsiveness of tax collection to economic growth poses new challenges for norms on sharing taxes with the states.
In this regard, here is a look at tax buoyancy trend and its impact on tax devolution.

What is tax buoyancy?

Tax buoyancy is one of the key indicators to assess the efficiency of a government’s tax system.
Generally, as the economy achieves faster growth, the tax revenue of the government also goes up.
Tax buoyancy explains this relationship between the changes in government’s tax revenue growth and the changes in GDP.
In other words, it measures the responsiveness of tax mobilisation to economic growth.

What are the determining factors?

Tax buoyancy depends largely on -
1. the size of the tax base
2. the friendliness of the tax administration
3. the reasonableness and simplicity of the tax rates

Look at just one year’s tax buoyancy to arrive at any conclusion on the tax system’s efficiency would be unfair.
There are many other factors at play in either boosting or pulling down tax buoyancy.
Also, there is a lag effect of taxation policies.
This can be captured only by examining the trend over a longer period of time.
Thus, tax buoyancy in a year may reflect the impact of an adverse set of developments during that year.
However, usually, the longer-term trend of tax buoyancy during a period of about 5 years results from policy changes made a few years earlier.
So, the lag effect of policy changes on tax buoyancy can hardly be ignored.

How has the trend been?

The highest tax buoyancy rate for the Union government during the last 28 years after economic reforms was achieved in 2002-03.
Tax buoyancy that year had risen to 2 at that time.
This meant that the Centre’s gross tax revenues had grown at double the rate at which the Indian economy had grown in nominal terms.

However, just a year before tax buoyancy hit the record high of 2, gross tax collections in 2001-02 actually declined.
This was even as the economy had clocked a nominal growth rate of just over 8%.
So, in the 5 years of 1999-2000 to 2003-04, there was poor tax buoyancy in 2 years and commendable tax buoyancy rates in the other 3 years.
The period thus holds the record for both the highest and the lowest tax buoyancy rates in post-reforms India.
During the 2004-05 to 2008-09 period, the first 4 years recorded tax buoyancy between 1.3 and 1.7, a creditable performance.
In the fifth year (2008-09), there was a sharp fall in tax buoyancy to about 0.2.
This was due to the impact of the global financial meltdown and the tax measures taken to alleviate its impact on the economy.
Thus, tax buoyancy was fairly moderate between 1 and 1.3 in 4 of these 7 years between 1991-92 and 1997-98 and was poor in the remaining 3 years.
But, the tax reforms undertaken during this period did help boost the tax buoyancy rate in the following decade.
Similarly, the tax reforms during 1999-2004, particularly in the indirect taxes regime, helped tax buoyancy in the 2004-09 period.
The period of 4 years between 2009-10 and 2011-12 saw tax buoyancy quite irregular.
The 2014-19 period saw steady performance in tax buoyancy.
In the first half of 2019-20, the Centre’s gross tax revenue grew by just 1.5% over the same period of 2018-19.
However, tax buoyancy fell further to about 0.15.
This is on the assumption that the nominal economic growth in the first half is 10%.

What does the slowdown indicate?

Deterioration in tax buoyancy in the recent year is a cause of concern for the central exchequer.
It can upset the government’s plans for fiscal consolidation.
It can also provide a misleading basis for the 15th Finance Commission’s calculations on sharing the Centre’s tax revenues with the states.
If the current low tax buoyancy is used to project the revenue growth for the next 5 years, revenue challenges for both the Centre and the states will only become more complicated.

What lies ahead?

The task before the 15th Finance Commission is how it can arrive at a more reliable base for calculating tax buoyancy in the coming years.
If it makes the wrong assessment now, the tax collection assumptions can become flawed, adversely affecting the new tax devolution formula.
So, getting a sense of the long-term and sustainable trend of tax buoyancy will be crucial for the tax sharing recommendations of the 15th Finance Commission.