Can the finance minister walk the fiscal tightrope?

As the finance minister prepares to present his next budget, he has the challenging task of garnering more revenue for fiscal consolidation and sustaining the Indian growth story, under the binding constraint of taming the persistent and spiralling inflation.

Given the current political landscape and with elections due in some states, carrying forward the desired fiscal reforms would be a tough call.

With the robust growth momentum this fiscal, the economic outlook remains buoyant. However, the downside risks mar the optimism. Inflation remains the government’s predominant worry, with the WPI rising to 8.4% and food inflation hovering near 17%.

The uncertain global economic recovery, increasing commodity and food prices, rising capital inflows putting pressure on the exchange rate and volatile industrial growth are some of the difficult issues that India has to contend with at this juncture.

In this backdrop, the government’s commitment to bring down the fiscal deficit to 3% by 2013-14 as indicated by the Thirteenth Finance Commission could be a challenge.

On the one hand, government spending would remain high on account of subsidies and various social sector schemes and on the other, it would not have the comfort of the one-off non-tax revenue windfall of more than Rs1 lakh crore from 3G and
broadband auctions in 2010-11.

The government has set an enhanced target of achieving a tax-GDP ratio of 11.5% and 11.8% in the next two fiscal years as against 10.8 % for 2010-11. Tax collections have been buoyant with the direct and indirect tax collections in the first three quarters exceeding the corresponding revenue last year by 19.5% and 42.8% respectively.

However, shackled by the inflationary pressures and political compulsions, the finance minister is unlikely to announce any increase in the current level of taxes. 

So what alternatives would the finance minister consider to raise tax revenues?

The way forward could be to follow the twin approach of broadening the tax base while keeping the rates low, and strengthening administration.
On the indirect taxes front, in keeping with the rate structure envisaged for the goods and services tax, and considering the inflationary impact of high duties, the finance minister is expected to maintain the current indirect tax rate structure.

However, rationalisation of the excise exemptions currently available for more than 350 goods is a step likely to be taken by the government for widening the tax base. The proposed GST framework includes only 99 items in the exempted category, which leaves sufficient scope to bring in more goods in the tax net, albeit in the lower tax bracket initially.

Many items such as processed foods are already being examined for the purpose. The government may also consider gradual calibration of the current excise exemption threshold at Rs1.5 crore to that proposed under the GST regime at Rs10 lakh, with the offer of a composition scheme to manufacturers.

Services constitute about 57% of the GDP and it is only natural that the government would seek to expand the base beyond 117 services. As a move toward transition to GST and in line with the international classification, more services would be brought in the tax ambit. 

In the case of direct taxes, the government is committed to implementing the Direct Taxes Code from April 2012 and would not like to disturb the current tax structure. However, administration, enforcement and compliance would certainly be the focal areas.

Across the globe, tax administrations are getting more focused in improving compliance. In the Indian context, the income tax department has spelled out its strategic plan in this direction for the next five years in its Vision 2020 document, which should be implemented in the right earnest.

With more than Rs2 lakh crore stuck in disputes and appeals, providing a mechanism to end unproductive litigation and making the Dispute Resolution Panel more effective receive immediate priority. The government could also try to settle more cases through the mutual agreement procedure and finalise advance pricing mechanism procedure for transfer pricing rules.

The government must renew its focus on strengthening the administrative and implementation procedures for reducing the cost of compliance. Sophisticated IT systems would enable seamless flow of information through the compliance chain.

The accelerating pace of globalisation enhances the risk of tax avoidance and calls for active participation by the revenue authorities in the global forums for information sharing and curbing abuses. Several countries have developed measures, with positive results, to incentivise taxpayers to disclose instances of aggressive tax planning.

In the UK, for instance, disclosure of tax avoidance schemes was instrumental in cutting off over £12 billion in avoidance opportunities in the first five and a half years. Back home, given the pressures to check tax evasion, the government would seek to revise double tax avoidance agreements for sharing tax information and tracking unaccounted money parked offshore.

The writer is a senior tax professional with Ernst & Young. Views expressed are personal.