Tax policy plays two important roles in financing economic development. One is to maintain an economy at a higher employment level so that the saving capacity of the people is raised with an increase in income per head.
The second is to raise the marginal propensity to save of the community as far above the average propensity to the maximum extent possible without discouraging work effort or violating canons of equity. Savings can be generated in two ways: by increasing real output or by a reduction in real consumption.
There is considerable disagreement among economists and policymakers about the usefulness, or necessity of taxation in raising resources for financing economic development in developing countries like India.
At the early stage of development, when the rate of raising is low, there is need for compulsion in forcing people to consume less and save more. Only through taxation it is possible to generate forced saving which is so essential for accelerating the rate of capital formation which is the sine qua non of high rate of per capita income growth.
Tax policy to raise the MPS above APS is concerned with the design and implementation of taxes to reduce private consumption. Tax revenue as a percentage of GNP is low in most developing countries, averaging between 15—20%, compared to 25—30% in developed countries. Moreover, direct taxes especially taxes on income, are a minor source of tax revenue compared with indirect taxes.
The proportion of the population that pays income tax in developing countries is correspondingly low, averaging about 10% compared to the vast majority of the working population in developed countries which constitutes between 20 to 40% of the total population. There would, therefore, appear to be a greater scope for using tax policy to raise the level of aggregate saving relative to income. Two important points may be noted in this context.
Nature of tax system:
First, the rudimentary nature of the tax system in developing countries is partly a reflection of the stage of development itself. Thus, the scope for increasing tax revenue as a proportion of income may in practice is limited.
Measuring the tax base:
Secondly, there are the difficulties of defining and measuring the tax base and of assessing and collecting taxes in circumstances where the population is scattered throughout the country, and primarily engaged in producing for subsistence and where the illiteracy rate is also high.
There is also the fact that, as far as income tax is concerned, the income of the vast majority of income-carers is so low that they fall outside the scope of the tax system. Whereas 70% of national income is subject to income tax in developed countries, only about 50% is subject to such taxation in developing countries.
In this context, A.P. Thirwall has argued that, “even if there was scope for raising considerably more revenue by means of taxation, whether the total saving would be raised depends on how tax payments are financed — whether out of consumption or saving — and how income (output) is affected. It is often the case that taxes which would make tax revenue highly elastic with respect to income are taxes which would be met mainly out of saving or have the most discouraging effects on incentives.”
Progressive income tax and saving:
In this context, we may cite the examples of progressive income tax which will discourage work effort if the substitution effect of the tax is stronger than the income effect; and to the extent the high marginal rates of tax fall primarily on the high-income groups (i.e., rich people) with low propensities to consume, saving may fall by nearly as much as tax revenue rises.
To avoid such large reductions in private saving, an expenditure tax on high income groups, which exempts saving from taxation, is a preferable alternative to a progressive income tax, but the disincentive effects on work effort are not necessarily avoided.
This is so because if the expenditure tax encourages saving, the tax rate must be higher to yield the same revenue as the income tax. If people work to consume and the prices of consumption goods are raised, work effort will be curtailed if the substitution effect of the change is stronger than the income effect.
The more successful the expenditure tax is in stimulating saving out of a given income, the higher must be the rate of tax to keep the economy from the two taxes equal, and the greater the discentive to work effort is likely to be.
In general, the most effective tax policy to raise the level of saving relative to income would be to impose taxes on those with high MFC, viz., the poor, keeping in view the obvious considerations of equity.
For achieving the best possible results, i.e., promoting growth without affecting the incentives to work hard and save taxes should be imposed on all non-profit incomes and luxury consumption. However, since most people in developing countries do not have taxable income (due to complete absence of agricultural income tax, low per capita income and widespread tax evasion and avoidance), the contribution of direct taxes is low.
In India, for example, the contribution of direct taxes to total tax revenue was 18.5% in 1995-96. This means that 81.5% of tax revenue was derived from indirect taxes. So, in order to raise adequate resources for development, the government is forced to extend the coverage of indirect taxes on mass consumption goods.
Furthermore, since agriculture is the backbone of the economy, and since huge amount of investments usually made in agriculture and allied activities in developing countries, agricultural taxation has to play an important role in resource mobilisation for planned economic development.
The predominant importance of agriculture in developing countries makes agricultural taxation a potentially significant source of tax revenue and a means of transferring resources into productive investment.
There are various instruments for taxing agriculture, including taxes on land area, on land value, on net income and on land transfer. If the object of the government is to raise revenue, then agricultural marketing and export taxes are probably the most efficient and the easiest to collect.
In theory, land taxes are probably the most desirable way to transfer resources from agriculture. But, in practice, land taxes are not important as a source of tax revenue.
In a modern market-based economy like that of India, the balance between direct taxes on income and indirect taxation on expenditure and trade is heavily weighted in the direction of the latter, particularly in the form of import duties and sales taxes.
Such taxes are easy to collect and administer but again business taxation may merely replace one form of saving for another. The MPS out of profits is usually high. The main justification for corporate taxation is to retain control of resources which might otherwise leave the country if the business is foreign-owned or to substitute public for private investment on the grounds that the public investment is more socially productive than its private counterpart.
However, taxation as a method of development finance creates certain problems. While involuntary savings may increase through financed reduction in consumption, voluntary savings may fall because individuals may try to protect their living standards by maintaining their existing consumption levels. This is likely to reduce the flow of funds to the private sector.
Moreover, taxation has a negative effect on incentives to work hard, save and take risk. So, work effort, saving and investment in venture capital (i.e., new enterprise) will fall. Moreover, taxation on agriculture may affect agricultural improvement. Instead of adopting measures for raising agricultural productivity through investment, farmers may prefer to consume more and save less.
Thus, it is absolutely essential to evolve an ideal tax system that is unlikely to have any adverse effect on work effort, saving, investment and enterprise (risk-taking) and does not violate the accepted notion of equity.
In short, the system of tax policy in developing countries like India is likely to exert considerable influence on saving and investment the two crucial determinant of economic growth. So, the primary objective of tax policy in such countries should be to transfer financial resources from the private to the public sector as much as possible with minimum adverse effect.
There is wide agreement among economists that in countries like India there is an untapped tax potential. In other words, there is considerable scope for broadening and deepening the tax system by improving the tax structure and by strengthening the tax collecting machinery.