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The following OECD assessment and recommendations summarise chapter 6 of the Economic survey of India survey of India published on 9 October 2007.
Does public expenditure need to be reoriented?
Despite increased use of PPPs in infrastructure provision, greater government investment outlays are needed and could be funded by a re organisation of public spending. At the same time, there is a need to reduce outlays on subsidies, which are much higher than in a number of emerging economies (such as Brazil and China). Moreover, electricity, food and petroleum subsidies do not reach the poorest groups in society because of poor administration and corruption. Indeed, the government estimates that to transfer one rupee to the poor by way of food and fuel subsidies it is necessary to spend almost four rupees. The government should reduce outlays on subsidies by better targeting them to reach poor people, as well as lowering support to companies, including loss-making public enterprises. In this way more funds could be made available for much needed infrastructure investment.
Reform of direct taxation also has the potential to further improve growth. Despite large cuts in direct tax rates, which have strengthened the economy, the share of direct tax revenues in GDP has risen. Nonetheless, the tax system still bears some traces of past interventionism, through extensive loopholes and exemptions which introduce distortions and complexity, facilitating tax evasion. They are most noticeable in the areas of saving, agriculture and corporate taxation. The treatment of some forms of savings is so favourable that they are often exempted from taxation at the time of initial savings, during the period when invested funds earn returns, and finally when investments are liquidated – a level of generosity that has rarely been found in the OECD area. Agricultural incomes are not subject to income tax and numerous exemptions exist in the corporate tax system. Indeed, these are so prevalent that corporate tax collections are only half of the theoretical yield. The government should consider reducing exemptions and loopholes in all these areas, creating room for cuts in statutory rates, thereby moving towards equalisation of effective tax rates across sectors and activities.
Significant reform of indirect taxation has also been undertaken, including the introduction of a destination-based, state-level VAT on goods in 2005. However, as taxes still represent a barrier to trade between states, further reform is needed to achieve a true internal market for goods and services. At present, there are a series of indirect taxes at the central and state levels that need to be integrated into a single tax that is neutral, both as to the sector and location of production, and minimises the possibilities for fraud. At present, the major barrier to inter-state trade is the Central Sales Tax and this is being phased out. When this process is completed, controls could be abolished on nearly all state borders as they would not be needed for this purpose. The government is committed to the introduction of a nation-wide goods and services tax by 2010 that would meet these objectives, but its final form has yet to be determined. Experience with VAT systems in Europe shows that careful design is necessary to simultaneously reduce trade barriers and contain fraud. The government should consider two options: either, moving to a national VAT with central revenue collection and redistribution of the tax yield to the states through a formula, or, introducing a two tier system that would allow both a central VAT and a state VAT. The first option would not exempt interstate exports while the second option would for the state VAT (as is currently the case) but not for the federal VAT. Such a system would maintain the audit chain in interstate trade (through the federal VAT), thereby facilitating tax enforcement. With this option states could retain a degree of fiscal sovereignty and could also set different tax rates. The second option would require close co-operation between state fiscal authorities to limit fraud. However, if this system were to also include a central rebatable VAT surcharge on cross-border trade, then fraud could be minimised.
Does the fiscal transfers system reduce differences in income across states?
In a country as large and diverse as India, a good system of revenue sharing across the country is essential. Without it, differences in government spending across states would be extremely large. Amongst the 20 largest states, incomes in the three richest states are three and a half times higher than in the three poorest states, which have a combined population of over 300 million people. Although the system of tax-sharing and inter-governmental transfers markedly reduces spending inequalities, it has become very complex and involves a degree of central control over state investment outlays that may be excessive. The government should simplify the transfer system, improve its administration and make it more transparent. It should further increase incentives towards fiscal discipline, in particular by replacing the obligation for states to borrow from the National Small Saving Fund, and thereby increasing their use of the capital market.
A major drawback of India’s fiscal federalism is that the local level of government remains underdeveloped. This is a particularly important inefficiency in a country where three quarters of the population lives in states with over 50 million inhabitants. Local authorities raise little tax revenue themselves and their autonomy to set rates is very limited. Key local activities have been retained in state-run boards and authorities, which have been generally inefficient in meeting the rising demand for local services. Such shortfalls hit the poorer parts of the population particularly hard and contribute to the relatively low rate of urbanisation in India, which restrains gains from agglomeration economies. Improving local public service provision is essential and requires an increase in the revenue base of local bodies, increasing tax-sharing with state governments and raising their autonomy, accountability and administrative abilities.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations. The complete edition of the Economic survey of India 2007 is available from:
For further information please contact the India Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat’s report was prepared in the Economics Department by Richard Herd, Paul Conway and Sean Dougherty, under the supervision of Willi Leibfritz. Research assistance was provided by Thomas Chalaux.