by Devesh Kapur, University of Pennsylvania
and Arvind Subramanian, Peterson Institute for International Economics
Op-ed in the Business Standard, New Delhi
February 7, 2014
© Business Standard
In our last piece, we had argued that taxation is the economic glue that binds citizens to the state in a necessary two-way relationship (India: Taxation's Fatal Neglect?). A citizen's stake in exercising accountability diminishes if he does not pay in a visible and direct way—typically via direct taxes or user fees—for the services the state provides. We estimated that a very small percentage of Indians (about 10 percent) are in this taxpayer accountability relationship with the state. Unless India brings more people into the tax net through some form of direct taxation, the promise of Indian democracy will remain unfulfilled. How should this be accomplished?
Four key factors bear upon this question. India is decentralizing. It is rapidly urbanizing. Wealth is increasingly vested and locked up in land and property. And politicians will be extremely reluctant to impose direct taxes, especially if they are close to those being taxed. Consider each in turn.
Given India's size, the chain of delegation from principals (citizens/voters) to agents (their elected representatives) is simply too long for the current system of taxation to serve as an accountability mechanism. In addition, top-down transfers to local governments, whether from centrally sponsored schemes or state governments, weaken citizens' engagement, and they become less demanding and politicians have fewer incentives to respond to public interests. Hence, an increasing share of public services and local public goods should be provided locally and financed locally, preferably via direct taxes.
The decentralization impulse that drove the 73rd and 74th constitutional amendments was appropriately visionary, but the fiscal means to realize that vision have not been provided to local bodies. The large vertical imbalance inherent in the massive mismatch between functions and finances of local governments, especially urban local bodies, violates the principle of "subsidiarity" that is the cornerstone of fiscal federalism. Often, the culprits are state governments and leaders who have deliberately throttled the fiscal powers of urban local bodies fearing a loss of political control if they gain financial autonomy. States such as Haryana, Punjab, and Rajasthan have even abolished the residential property tax.
Second, going forward, decentralization will increasingly be focused on cities. If 50 to 60 percent of India's population will be urban, cities will and should become the vehicle or the governance mechanism for delivering a variety of public services such as primary education and health, water and sanitation, local transportation, and law and order. The taxpayer accountability relationship will then become about urban taxes and urban user fees. Moreover, creating local taxation capacity will serve to strengthen state capacity to provide public goods.
Third, land in general—and urban land and property in particular—is among the biggest sources of wealth in the country, but it has been untapped. The limited data available suggest that total municipal revenues in India account for about 0.75 percent of gross domestic product, about one-seventh of Brazil's. Urban local bodies account for about two percent of the combined revenue and expenditure of all levels of the government, less than a tenth of that in advanced countries.
Finally, in India, the closer a tier of the government is to the taxed and the more direct the representation of the taxed, the less willing it is to tax. Municipal corporations find it more difficult to increase these taxes, perhaps because property owners and builders pay for the campaigns of corporators. Similarly, village panchayats are unlikely to impose taxes on the very people who might control or constitute them.
Thus, the 14th Finance Commission should take the lead and initiate the process of tax decentralization. It should do so not by fiat but through the provision of incentives to states and local governments.
These incentives would take the form of the Centre providing additional resources by way of matching grants (via Finance Commission transfers) for local governments and states that make progress in increasing the number of taxpayers who are brought into the direct taxpayer net and increasing revenues from such direct taxes. For example, the Finance Commission could say that for every Y percent increase in these two variables, central matching grants would increase by X percent. The resources could come by increasing the share of pooled revenue that is distributed to the states (so-called vertical transfers).
The exact incentive mechanism could be designed in several ways. If the view is that state governments are the impediment in preventing financial empowerment of local bodies, the Finance Commission could stipulate that the matching grant from the Centre would be linked to improved performance by the local bodies and would be given to these bodies and not to state governments.
An alternative, and less intrusive (on state government authority), approach would be to provide matching grants to the states conditional on improving property tax performance and leave it to state governments via the state finance commissions to determine the subsequent allocations to local bodies.
The light or heavy touch should also apply to the specifics of taxation. For example, if there is a universal view that urban property taxes are the way to go, the Finance Commission can explicitly link the matching grants to performance on additional property taxpayers and property taxes. The arguments for privileging a property tax are several. First and foremost, it is a direct tax that will be felt by those on whom it is imposed, thereby furthering the accountability objective. It would significantly boost revenues. It is a progressive wealth tax, even when it is uniform and low. It is imposed on a non-mobile good, which can with today's technologies be relatively easily identified and mapped. It is also a tax imposed on a good (property) whose values can only increase, and therefore has in-built tax buoyancy. And just as a financial transaction tax would put sand in the wheels of finance, it would do the same for property speculation.
The other variable the Finance Commission has at its disposal is the magnitude of matching grants. If fiscal decentralization is considered important—as we would urge—then the magnitudes set aside for achieving this objective should be substantial. However, if additional resources are unavailable, an alternative would be to change the formula for distribution of resources between states (so-called horizontal transfers) to include the performance criteria proposed above, according it a high weight in the distribution formula. This has the downside of being a zero-sum exercise between states that would elicit political resistance from the states that are likely to remain property tax laggards.
The challenges in building effective systems of property taxation will be considerable and local bodies will need assistance from the Centre and other institutions to do so. One implication is that this proposal should be implemented in a phased manner. For example, we could begin with municipal corporations, then municipalities and subsequently nagar panchayats and finally village panchayats. Successive Finance Commissions should calibrate the incentive mechanism to take account of past experience. But the end goal must be that nearly all Indians are part of the direct, especially property, tax net. And yes, this should include rural Indians as well.
With India poised to add half a billion people to its urban population over the next four decades, getting urbanization right is critical. In turn, an efficient property tax system is essential for urban revenue generation and service delivery. It may well be essential to sustain Indian democracy itself.
Op-ed: India: Taxation's Fatal Neglect? January 19, 2014
Op-ed: What Saved the Rupee? October 17, 2013
Testimony: Assessing the Investment Climate in India and Improving Market Access in Financial Services in India September 25, 2013
Working Paper 11-17: India’s Growth in the 2000s: Four Facts November 2011
Op-ed: India's Weak State Will Not Overhaul China August 16, 2010
Policy Brief 09-15: India-Pakistan Trade: A Roadmap for Enhancing Economic Relations July 2009
Working Paper 09-11: The Impact of the Financial Crisis on Emerging Asia November 2009
Op-ed: The Growth Future—India and China August 19, 2008
Speech: Some Perspectives on the Indian Economy October 17, 2007
Book: Reintegrating India with the World Economy March 2003