The Hindu Business Line : What is the optimum rate of tax?

A flat tax revolution is now sweeping Central and Eastern Europe. Disgusted with the oppression and unnecessary trouble that people suffer at the hands of the tax collector, these countries have taken to the flat or proportional tax as a way out to secure a simplified system free from the arbitrariness of the progressive tax code with its built-in deductions, exemptions and tax breaks, says T. C. A. Ramanujam.

THE search for the optimum tax rate has been at the centre of all debates concerning tax reforms world over. It was the US that started the tax reform movement in the 1980s.

It simplified the tax code in 1986 and spent the next two decades feverishly "unsimplifying" it and, to quote The Economist, may soon be coming to a point of "renewed fiscal catharsis".

Rich countries have exhibited a greater tolerance for tax code sclerosis. The Economist believes that the final solution lies in the adoption of the flat tax regime.

Income-tax is of three types — (i) progressive tax, where the rate increases with the higher slabs of income, (ii) proportional tax where the rate remains constant at all levels of income, and (iii) regressive tax, where the rate comes down as you approach higher slabs of income.

Economists and policy-framers have always sworn by the progressive tax principle. But no longer. A flat tax revolution is now sweeping Central and Eastern Europe.

Disgusted with the vexation, oppression and unnecessary trouble that people suffer at the hands of the tax collector, these countries have taken to the flat or proportional tax as the way out to secure a simplified tax system which will be free from the arbitrariness of the progressive tax code with its built-in deductions, exemptions and tax breaks.

Estonia was the first country to introduce the flat tax replacing the three tax rates on personal and corporate profits with one uniform rate of 26 per cent in 1994. Latvia and Lithuania soon followed suit.

Russia adopted the flat tax rate on personal income in 2001 followed by Slovakia. Between 2000 and 2003, seven members of the OECD cut the number of brackets.

Says The Economist: "Fewer brackets are simpler to administer, but one bracket is simplest of all. Under a pure flat tax, the taxman takes the same cut from the last dollar you earn that he took from the first".

The introduction of the flat tax regime led to a remarkable turnaround in government revenues in Russia. The replacement of the rates of 12 per cent, 20 per cent and 30 per cent bands into a single uniform rate of 13 per cent from January 1, 2001 led to a rise by 26 per cent more in revenues in real terms.

The Institute of Fiscal Studies in London discovered a consequential increase in compliance with the tax authorities from 52 per cent to 68 per cent. Russia's tax system became easier to administer and easier still to comply with.

Unlike Russia, other countries adopted a uniform rate for both corporate and non-corporate incomes. Spain and Germany have been toying with the idea of a uniform 30 per cent flat tax on all personal and corporate incomes. Estonia has gained much by way of growth and increase in revenues.

Cost of compliance

Taxes are often "much more burdensome to the people than they are beneficial to the sovereign" (Adam Smith). The American Treasury estimates the total cost of compliance with the income-tax law at about $125 billion a year.

For every $100 it collects as net tax revenue, the American IRS spends 52 cents, and its French counterpart $1.44.

Two American scholars Marsha Blumenthal and Joel Stemrod have estimated that the average American taxpayer spends 27.4 hours to file his tax returns. "Trouble, vexation and oppression are the price Americans pay for the tax exemptions, deductions and concessions they cherish so much".

Jeffrey Owens and Stuart Hamilton of the OECD have drawn pointed attention to the fact that the tax-codifiers and tax-dodgers are locked in a mutually destructive "arms race".

The code is made more complex, because of tax wheezes. More people then seek to avoid taxes. The best way to fight tax avoidance, according to the OECD economists, is with simplicity.

India's experience with tax rates

India's experience with tax rates is a long story. There were 11 slabs with rates ranging from 10 to 85 per cent in 1973-74.

The former Primer Minister, Mr V. P. Singh, reduced the slabs to four and cut the top marginal tax rate to 50 per cent. Dr Manmohan Singh further reduced the slabs to three and introduced the rates of 20, 30 and 40 per cent.

The present Finance Minister reduced the maximum marginal rate for personal income-tax to 30 per cent. Dr Vijay Kelkar, who headed the committee on tax reforms, suggested just two slabs, 20 per cent and 30 per cent but this has not come about.

Recent studies have shown that since the beginning of tax reforms, the cost of compliance in India has gone up substantially. The latest Finance Act has aggravated the problem of costs by imposing such additional taxes as the Fringe Benefit Tax and the cash withdrawal tax.

A study by the National Institute of Public Finance and Policy commissioned by the Planning Commission estimated the compliance cost of personal income tax in India to be as high as 48 per cent.

Naturally, in the words of Dr Kelkar, "such high costs raise serious doubts about income tax as an efficient source of revenue.

The burden of compliance cost is essentially regressive and a simplified tax structure will reduce the transaction costs making the tax code progressive".

In the words of the Chelliah Committee, the income tax department is in a shambles. It has adequate manpower but the majority of personnel includes Inspectors and Clerks who are not adequately trained.

Its tasks are made difficult by the combination of high rates and the amoral attitude to tax obligations of a large section of the potential assesses as well as the nexus between influential assesses and political elements.

"The inherent defects of a progressive real-world income tax, the iniquities caused by tax shelters, the unequal and onerous impact of the interaction of inflation and the combined effect of all direct taxes, the unsatisfactory state of tax administration and the disadvantages it suffers from because of external factors, the inability of the legal system of the country to cope with the problem of growing delinquency, and the resultant impunity with which taxes are evaded — all of this requires that we thoroughly re-structure the tax system and overhaul its administration".

There can be arguments based on the marginal utility theory, how a rupee saved by way of tax is more valuable to those in the lower income groups when compared with those in the higher income brackets.

But the simplicity of the flat tax and accompanying removal of exemptions and deductions and the avoidance of the problem of "bracket creep" and the "missing middle" will more than compensate for the theoretical arguments in favour of the present muddled progressive tax system.

We can still have a flat tax regime as an experimental measure for some years.

(The author is a former Chief Commissioner of Income-Tax.)

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