## 1. Empirical Evidence on Taxation and Growth

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### I. Introduction and Overview
- India’s ratio of tax revenue to GDP is low by international standards, while marginal rates are high.
- Cross-country studies show a generally negative impact of a high tax burden on economic activity, but results are not robust; firm-level evidence and simulation results more conclusively show adverse effects of high tax rates on growth and distortions in financing and investment decisions (Box 1).
- High tax rates may also contribute to the growth of the “shadow economy,” with costs in foregone tax receipts and lower productivity growth.
- Policy thrust of considered tax reforms: combine lower statutory rates with base broadening to raise revenues while lowering the marginal tax burden and removing distortions, potentially enabling an “expansionary” fiscal adjustment.

### II. Empirical Findings (summarized from Box 1)
- Labor taxation:
  - High labor taxation can push up labor costs, reduce labor demand, induce substitution away from labor, lower the marginal product of capital, and reduce investment and growth.
  - Empirical evidence for EU countries supports negative labor-tax effects on employment and growth.
- Consumption taxes:
  - In theory neutral with respect to savings and investment; empirical evidence is mixed.
  - Some studies find no impact on employment and growth, others find negative impacts (including on savings).
- Corporate taxes:
  - Raise required rate of return and depress investment.
  - Tend to favor debt over equity and retained earnings, potentially creating inefficient allocation of resources and disadvantaging smaller firms.
  - Non-neutral due to rebates, exemptions, and special regimes that thin out the tax base and benefit large firms.
- Taxation of capital income:
  - Even low levels appear distortionary for savings composition and location.
  - Cross-country evidence for EU shows limited effect on aggregate savings but effects on composition and location.
- Summary of evidence types:
  - Cross-country studies: negative link between tax burden and growth for high-income countries; less clear for low- and middle-income countries.
  - Firm-level and CGE simulation studies: support view that higher taxes negatively affect growth.

### III. Main Features of the Indian Tax System (December 2005)
- Tax authority division:
  - Central government levies: personal income tax (PIT), corporate tax (CIT), customs and excise duties, service tax, and a sales tax on inter-state transactions (CST).
  - State governments levy: VAT on goods (state VAT), state sales taxes, and various local taxes.
- Incentives: tax holidays are a prominent form of tax incentives, which have thinned the overall tax base.
- Reforms since 1991:
  - Reductions in customs and excise duties; lowering CIT rates; partial extension of VAT to some industries; broadening tax base to some services.
  - State-level introduction of VAT in 2005 in 24 states and union territories.
- Principal direct taxes and parameters (Box 2):
  - PIT rates: 10 percent–31.5 percent.
  - PIT exemption threshold: Rs. 111,250 (US$2,472); base of about 40 million taxpayers.
  - Wealth tax threshold: net assets in excess of Rs. 1.5 million (US$33,333).
  - CIT rate for domestic companies (including surcharges): 33.66 percent, with significant exemptions.
  - Dividend distribution tax: 12.75 percent (including surcharges).
  - Other corporate levies: minimum alternative tax on profits, tax on fringe benefits, various withholding taxes on interest, royalties, etc.
- Main indirect taxes:
  - State VAT and sales taxes; central customs and excise duties; central service tax; CST on interstate trade.
  - VAT rates in VAT-implementing states: 1 percent, 4 percent, and 12.5 percent.
  - Service tax: levied by the center on some 71 services.
  - CENVAT base truncated to manufacturing and eroded by exemptions (e.g., small-scale industries and Special Economic Zones).
  - Other minor taxes: stamp duty, taxes on land and buildings, taxes on motor vehicles.

### IV. Stylized Facts and Key Statistics
- Aggregate tax burden and trends:
  - After declining below 14 percent of GDP in 2001/02, India’s general government tax revenue rebounded to 15¾ percent of GDP in 2004/05.
  - This 15¾ percent of GDP exceeds the average for Asian emerging market countries by over 1 percentage point, but is 3¾ percentage points below the average for all emerging market countries.
  - Decline in revenue in the 1990s coincided with major tax reforms; direct tax revenues increased while indirect tax collections declined (mainly due to tariff reductions).
  - Recent developments: peak tariff reduction for non-agricultural imports (Kelkar 2002 proposals) was fully implemented; revenue loss was more than offset by buoyant corporate tax collections. Excise and PIT revenues rose only marginally due to further exemptions, deductions, and rebates. States raised sales tax collections; VAT introduced in 2005.
- Structure and composition:
  - Tax structure remains dominated by indirect taxes.
  - State taxes on commodities and services represent nearly a third of total general government tax revenue.
  - Central government excises represent one-fifth of total general government tax revenue.
  - The share of revenue from indirect taxes exceeds two-thirds of total tax intake.
- Selected numeric breakdown (India: Structure of General Government Tax Revenue, 2004/05):
  - Total: 4,884.5 (Billions of Rupees); 15.7 percent of GDP; 100.0 percent of total.
  - Central government: 3,049.8; 9.8 percent of GDP; 62.4 percent of total.
    - Corporate tax: 835.7; 2.7 percent of GDP; 17.1 percent of total.
    - Income tax: 483.1; 1.6 percent of GDP; 9.9 percent of total.
    - Excises: 991.6; 3.2 percent of GDP; 20.3 percent of total.
    - Customs: 576.6; 1.9 percent of GDP; 11.8 percent of total.
    - Other (mostly service tax): 162.9; 0.5 percent of GDP; 3.3 percent of total.
  - States and union territories: 1,834.7; 5.9 percent of GDP; 37.6 percent of total.
    - Taxes on income (states): 16.4; 0.1 percent of GDP; 0.3 percent of total.
    - Taxes on property and capital transactions: 215.3; 0.7 percent of GDP; 4.4 percent of total.
    - Taxes on commodities and services: 1,602.9; 5.2 percent of GDP; 32.8 percent of total.
- National savings context:
  - National savings during 1999–2004 in India: 24 percent of GDP on average annually, compared to 43 percent in China, 34 percent in Malaysia, and 32 percent in Korea.

### V. Issues and Distributional/Behavioral Implications
- Despite base-broadening rhetoric, exemptions, rebates, and special regimes have persisted and reduced tax productivity.
- High marginal effective tax rates create distortions in investment and financing decisions, favoring debt over equity and disadvantaging firms reliant on internal funds or facing borrowing constraints.
- Tax incentives and holidays thin out direct and indirect tax bases and create inequities and inefficiencies.
- Consumption taxes are theoretically neutral but empirically may affect savings and labor-leisure choices; evidence is mixed.
- Reforms aimed at lowering statutory rates and broadening bases are expected to improve tax productivity, lower marginal tax burdens, and reduce tax-induced distortions — though some firms (internal-fund–dependent or credit-constrained) may continue to face high marginal tax rates.

### Kelkar 2002 Reports’ Proposals — principal elements
- Personal Income Tax (PIT):
  - Change exemption level and rate structure; broaden the base; eliminate most exemptions and replace allowances by credits.
  - Constitutional amendment to allow taxation of agricultural income.
  - General exemption increased, number of brackets reduced, and highest marginal rate reduced to 30 percent.
  - A range of special deductions to be eliminated with some converted into credits.
  - Proposed exempting dividends from Indian companies and long-term capital gains on equity.
- Corporate Income Tax (CIT):
  - Reduce rate and large number of deductions and exemptions.
  - Rate proposals: from 35 percent (net of 2 percent surcharge) to 30 percent for domestic companies; from 40 percent to 35 percent for foreign companies.
  - Eliminate the minimum alternate tax.
- Import tariffs and export promotion:
  - Rationalize structure: existing 20 tariff rates (ranging up to 182 percent) would be reduced to a range of 0-20 percent for most goods, with higher rates—up to 150 percent—for certain agricultural products and “demerit” goods.
  - Significantly narrow exemptions.
- Indirect taxes:
  - Broaden the base of the CENVAT and move it further toward a VAT.

### AETR, METW, METR and tax productivity findings (Kelkar summary)
- AETR on labor:
  - 2 percent in 2001, much lower than in the European Union, United States, or Japan, which range from 21–36 percent.
- Reasons for low AETRs:
  - India’s narrow tax base and the lack of a social security system.
  - AETR on capital income is low owing to wide coverage of tax incentives, low personal taxes on capital income, and a large informal sector.
- Informal sector proxy:
  - Operating surplus of unincorporated enterprises accounted for three quarters of the operating surplus of the economy in 2000/01.
- CIT tax productivity is much below the average for both OECD and non-OECD countries, reflecting a tax base thinned-out by exemptions and widespread tax evasion.
- Scope for revenue increases without raising statutory rates via:
  - Expansion of the taxpayer net.
  - Lifting of exemptions.
  - Stepped-up tax administration and compliance.
- METW findings:
  - Marginal tax wedge in India is 1.4 percent (slightly below the OECD average).
  - Standard deviation of the marginal tax wedge across investment assets is three times higher than the OECD average.
  - Debt financing yields a negative tax wedge (a government subsidy for marginal debt-financed investments).
  - Investments financed by new equity face a below-average tax wedge; investments financed by retained earnings face a tax wedge in excess of 2½ percent (OECD average: 2 percent).
  - Firms relying on internal financing are particularly penalized.
  - Average debt-to-equity ratio for Indian companies rose to 1.4 in 2002 from a low of 1.2 in 1996.
- METR findings:
  - METR for investments financed by retained earnings or equity is nearly 33 percent, compared to the OECD average of 22 percent.
- Sectoral and regional variation:
  - Firms benefiting from corporate tax exemptions face a marginal tax wedge of 0.4 percent, one full percentage point lower than firms without tax holidays.
  - Accelerated depreciation and other incentives lower the marginal tax burden for benefiting firms, producing large variations in METWs and allocative distortions.

### Priorities for reforms and assessment of the FRBMA road map
- Reform strategy advocated:
  - Combine lower statutory rates with base broadening to achieve pro-growth fiscal adjustment.
  - Remove exemptions and improve tax administration and compliance to raise direct tax revenue without higher statutory rates.
  - Lower statutory rates further to enhance neutrality and returns of the tax system.
  - Introduce a national VAT (GST) on goods and services to improve revenue productivity of domestic indirect taxes and recoup expected trade revenue losses; enhance economic efficiency.
- FRBMA road map tax proposals:
  - Direct tax measures proposed:
    - Reduce CIT rate to 30 percent and eliminate the surcharge.
    - Reduce the general depreciation rate to 15 percent.
    - Eliminate the withholding tax on distribution of dividends.
    - Eliminate the long-term capital gains tax.
    - Several measures (reduction in CIT and depreciation rates, elimination of long-term capital gains tax) have been implemented over the last two years; remaining measures in the 2006/07 budget would help consolidate gains.
  - Indirect tax measures proposed:
    - Introduce the GST to replace state VAT, CST, central excise duties, and central service tax.
    - Further reduce customs duties to levels in ASEAN member countries; tariffs have already dropped in the last two budgets with further cuts envisaged.
  - Tax productivity and administration measures:
    - Remove most exemptions and incentives; expand the taxpayer net.
    - Increase reliance on information technology: computerization of tax administration, increased withholding at source, a tax information network and tax information system to track interstate transactions, and computerization of customs.
    - Planned introduction of large taxpayer units in major cities in 2006 to reduce compliance and transaction costs for large taxpayers.
- Implementation caveats:
  - Most exemptions remain in place despite government announcements; some sunset clauses extended and new incentives introduced (e.g., 2005 Special Economic Zones Act).
  - New services have been added to the tax net over the last two years, but moving toward a GST requires further expansion of the service tax base and removal of most excise exemptions, including for small-scale industries and selected areas.
- Expected impact:
  - Implementation of remaining tax reforms would further decrease the marginal tax burden on investment and reduce tax-induced distortions; the METW would decrease further.

### Neutrality of the tax system and corporate financing (post-reform assessment)
- Reform would raise overall neutrality, but firms relying on internal financing (mainly smaller firms) would remain relatively penalized.
- The marginal tax wedge faced by firms relying on internal finance would remain ¼ percentage point above the OECD average.
- The standard deviation of the METW across investment assets would remain more than double the OECD average, indicating scope for further improvements.
- Policy measures to mitigate excessive reliance on debt finance and improve neutrality include:
  - Limiting deductibility of interest to a percentage of net taxable income.
  - Limiting debt for the purposes of income tax (examples cited: Canada limited to 2; Germany to 1.5; Japan to 3).
  - Limiting interest deductible to a referential rate (example cited: Portugal, the 12-month Euribor plus 1.5 percent).
  - Introducing an allowance for corporate equity.
- Footnote examples of equity-related measures: the notional rate of return on invested equity is deductible under the CIT in Croatia (1994–2001), and imputed equity return is taxed at a reduced rate in Austria and Italy (until 2001).

### Base-broadening, projected revenue and tax productivity gains
- Corporate tax revenue projection:
  - Corporate tax revenue is projected to nearly double from 2.3 percent of GDP in 2003/04 to 4.2 percent of GDP by 2008/09, despite a lower CIT rate, as most exemptions are eliminated.
- CIT tax productivity:
  - CIT tax productivity would more than double to 14 percent by 2008/09 (nearing the non-OECD average).
- Removal of most tax incentives would reduce variation of marginal tax burden across sectors and regions, contributing to higher economic efficiency.
- Proposed GST with few exemptions should enhance indirect tax productivity and improve economic efficiency.

### Tax measurement methodology and parameter data (December 2005)
- AETR on labor:
  - Step 1: Effective tax rate on total household income = ratio of individual income tax to household income (including operating surplus of unincorporated enterprises (OSPUE), property income (PEI), and wage income (CE)).
  - Step 2: AETR on labor = (taxes paid on labor income—tax on wages and salaries calculated by applying the household income AETR to wage income—plus social security contributions and other payroll taxes) divided by (wages and salaries plus employer-paid social security contributions).
- AETR on capital:
  - Obtained by dividing the sum of taxes paid by capital (corporate income tax, household taxes on capital income, and various property taxes) by the net operating surplus of the economy.
- AETR on consumption:
  - Calculated as the sum of domestic taxes on goods and services, export, and import duties divided by the sum of private and government nonwage consumption, net of indirect taxes.
  - Indirect taxes are excluded in the denominator to express indirect tax rates as a percentage of the price before tax (Mendoza et al., 1994 approach).
  - Alternative approach: express the consumption tax base in gross terms (including indirect taxes in the denominator) to improve comparability (Carey and Rabesona, 2002).
- Assumption: Labor and capital income of households are assumed to be taxed at the same rate.
- Tax parameter data (December 2005) — key rates and parameters (In percent):
  - Corporate Tax System:
    - Corporate tax rate on retained earnings: 33.66
    - Inventory valuation: FIFO
    - Long-term capital gains tax rate: 0
    - Dividend distribution tax rate: 12.75
  - Personal Tax System:
    - Interest income tax rate: 10.71
    - Dividend income tax rate: 0
    - Short-term capital gains tax rate: 10.2
    - Long-term capital gains tax rate: 0
    - Proportion of assets realized each period: 10
  - Tax Depreciation Rates:
    - Machinery: Depreciation method = Declining balance; Rate for declining balance = 15
    - Buildings: Depreciation method = Declining balance; Rate for declining balance = 10

*Source: IMF staff paper excerpt, “1. Empirical Evidence on Taxation and Growth.”*

### 1. Empirical Evidence on Taxation and Growth...............................................................4

### 1. Empirical Evidence on Taxation and Growth

### I. Introduction and Overview
- India’s ratio of tax revenue to GDP is low by international standards, while marginal rates are high.
- Cross-country studies show a generally negative impact of a high tax burden on economic activity, but results are not robust; firm-level evidence and simulation results more conclusively show adverse effects of high tax rates on growth and distortions in financing and investment decisions (Box 1).
- High tax rates may also contribute to the growth of the “shadow economy,” with costs in foregone tax receipts and lower productivity growth.
- Policy thrust of considered tax reforms: combine lower statutory rates with base broadening to raise revenues while lowering the marginal tax burden and removing distortions, potentially enabling an “expansionary” fiscal adjustment.

### II. Key empirical points from Box 1 (Empirical Evidence on Taxation and Growth)
- Labor taxation:
  - High labor taxation can push up labor costs, reduce labor demand, induce substitution away from labor, lower the marginal product of capital, and reduce investment and growth.
  - Empirical evidence for EU countries supports negative labor-tax effects on employment and growth.
- Consumption taxes:
  - In theory neutral with respect to savings and investment; empirical evidence is mixed.
  - Some studies find no impact on employment and growth, others find negative impacts (including on savings).
- Corporate taxes:
  - Raise required rate of return and depress investment.
  - Tend to favor debt over equity and retained earnings, potentially creating inefficient allocation of resources and disadvantaging smaller firms.
  - Non-neutral due to rebates, exemptions, and special regimes that thin out the tax base and benefit large firms.
- Taxation of capital income:
  - Even low levels appear distortionary for savings composition and location.
  - Cross-country evidence for EU shows limited effect on aggregate savings but effects on composition and location.
- Summary of evidence types:
  - Cross-country studies: negative link between tax burden and growth for high-income countries; less clear for low- and middle-income countries.
  - Firm-level and CGE simulation studies: support view that higher taxes negatively affect growth.

### III. Main Features of the Indian Tax System (December 2005)
- Tax authority division:
  - Central government levies: personal income tax (PIT), corporate tax (CIT), customs and excise duties, service tax, and a sales tax on inter-state transactions (CST).
  - State governments levy: VAT on goods (state VAT), state sales taxes, and various local taxes.
- Incentives: tax holidays are a prominent form of tax incentives, which have thinned the overall tax base.
- Reforms since 1991:
  - Reductions in customs and excise duties; lowering CIT rates; partial extension of VAT to some industries; broadening tax base to some services.
  - State-level introduction of VAT in 2005 in 24 states and union territories.
- Principal direct taxes and parameters (Box 2):
  - PIT rates: 10 percent–31.5 percent.
  - PIT exemption threshold: Rs. 111,250 (US$2,472); base of about 40 million taxpayers.
  - Wealth tax threshold: net assets in excess of Rs. 1.5 million (US$33,333).
  - CIT rate for domestic companies (including surcharges): 33.66 percent, with significant exemptions.
  - Dividend distribution tax: 12.75 percent (including surcharges).
  - Other corporate levies: minimum alternative tax on profits, tax on fringe benefits, various withholding taxes on interest, royalties, etc.
- Main indirect taxes:
  - State VAT and sales taxes; central customs and excise duties; central service tax; CST on interstate trade.
  - VAT rates in VAT-implementing states: 1 percent, 4 percent, and 12.5 percent.
  - Service tax: levied by the center on some 71 services.
  - CENVAT base truncated to manufacturing and eroded by exemptions (e.g., small-scale industries and Special Economic Zones).
  - Other minor taxes: stamp duty, taxes on land and buildings, taxes on motor vehicles.

### IV. Stylized Facts and Key Statistics
- Aggregate tax burden and trends:
  - After declining below 14 percent of GDP in 2001/02, India’s general government tax revenue rebounded to 15¾ percent of GDP in 2004/05.
  - This 15¾ percent of GDP exceeds the average for Asian emerging market countries by over 1 percentage point, but is 3¾ percentage points below the average for all emerging market countries.
  - Decline in revenue in the 1990s coincided with major tax reforms; direct tax revenues increased while indirect tax collections declined (mainly due to tariff reductions).
  - Recent developments: peak tariff reduction for non-agricultural imports (Kelkar 2002 proposals) was fully implemented; revenue loss was more than offset by buoyant corporate tax collections. Excise and PIT revenues rose only marginally due to further exemptions, deductions, and rebates. States raised sales tax collections; VAT introduced in 2005.
- Structure and composition:
  - Tax structure remains dominated by indirect taxes.
  - State taxes on commodities and services represent nearly a third of total general government tax revenue.
  - Central government excises represent one-fifth of total general government tax revenue.
  - The share of revenue from indirect taxes exceeds two-thirds of total tax intake.
- Selected numeric breakdown from Table 1 (India: Structure of General Government Tax Revenue, 2004/05):
  - Total: 4,884.5 (Billions of Rupees); 15.7 percent of GDP; 100.0 percent of total.
  - Central government: 3,049.8; 9.8 percent of GDP; 62.4 percent of total.
    - Corporate tax: 835.7; 2.7 percent of GDP; 17.1 percent of total.
    - Income tax: 483.1; 1.6 percent of GDP; 9.9 percent of total.
    - Excises: 991.6; 3.2 percent of GDP; 20.3 percent of total.
    - Customs: 576.6; 1.9 percent of GDP; 11.8 percent of total.
    - Other (mostly service tax): 162.9; 0.5 percent of GDP; 3.3 percent of total.
  - States and union territories: 1,834.7; 5.9 percent of GDP; 37.6 percent of total.
    - Taxes on income (states): 16.4; 0.1 percent of GDP; 0.3 percent of total.
    - Taxes on property and capital transactions: 215.3; 0.7 percent of GDP; 4.4 percent of total.
    - Taxes on commodities and services: 1,602.9; 5.2 percent of GDP; 32.8 percent of total.
- National savings context (for motivation of reforms):
  - National savings during 1999–2004 in India: 24 percent of GDP on average annually, compared to 43 percent in China, 34 percent in Malaysia, and 32 percent in Korea.

### V. Issues and Distributional/Behavioral Implications Highlighted
- Despite base-broadening rhetoric, exemptions, rebates, and special regimes have persisted and reduced tax productivity.
- High marginal effective tax rates create distortions in investment and financing decisions, favoring debt over equity and disadvantaging firms reliant on internal funds or facing borrowing constraints.
- Tax incentives and holidays thin out direct and indirect tax bases and create inequities and inefficiencies.
- Consumption taxes are theoretically neutral but empirically may affect savings and labor-leisure choices; evidence is mixed.
- Reforms aimed at lowering statutory rates and broadening bases are expected to improve tax productivity, lower marginal tax burdens, and reduce tax-induced distortions — though some firms (internal-fund–dependent or credit-constrained) may continue to face high marginal tax rates.

*Source: IMF staff paper excerpt, “1. Empirical Evidence on Taxation and Growth.”*

### Box 3. Kelkar 2002 Reports’ Proposals

### Box 3. Kelkar 2002 Reports’ Proposals

### Kelkar task force — principal proposals
- Set up in 2002 to propose far-reaching reform agenda for direct and indirect taxes.
- Personal Income Tax (PIT):
  - Change exemption level and rate structure; broaden the base; eliminate most exemptions and replace allowances by credits.
  - Constitutional amendment to allow taxation of agricultural income.
  - General exemption increased, number of brackets reduced, and highest marginal rate reduced to 30 percent.
  - A range of special deductions to be eliminated with some converted into credits.
  - Proposed exempting dividends from Indian companies and long-term capital gains on equity.
- Corporate Income Tax (CIT):
  - Reduce rate and large number of deductions and exemptions.
  - Rate proposals: from 35 percent (net of 2 percent surcharge) to 30 percent for domestic companies; from 40 percent to 35 percent for foreign companies.
  - Eliminate the minimum alternate tax.
- Import tariffs and export promotion:
  - Rationalize structure: existing 20 tariff rates (ranging up to 182 percent) would be reduced to a range of 0-20 percent for most goods, with higher rates—up to 150 percent—for certain agricultural products and “demerit” goods.
  - Significantly narrow exemptions.
- Indirect taxes:
  - Broaden the base of the CENVAT and move it further toward a VAT.

### AETR and the overall tax burden
- The overall tax burden, as measured by the AETR, is low compared to advanced economies and higher-income emerging markets in the region.
- AETR on labor:
  - 2 percent in 2001, much lower than in the European Union, United States, or Japan, which range from 21–36 percent.
- Reasons for low AETRs:
  - India’s narrow tax base and the lack of a social security system.
  - AETR on capital income is low owing to wide coverage of tax incentives, low personal taxes on capital income, and a large informal sector.
- Informal sector proxy:
  - Operating surplus of unincorporated enterprises accounted for three quarters of the operating surplus of the economy in 2000/01.
- Comparative position:
  - India’s low AETRs on capital and labor match those of Sri Lanka and China, but are much below Korea and Thailand.
- Consumption tax:
  - AETR on consumption is broadly average despite a tax base that largely excludes services; it has declined over time.

### Tax productivity and corporate tax revenue
- AETRs are relatively low mainly owing to low tax productivity.
- CIT tax productivity is much below the average for both OECD and non-OECD countries, reflecting a tax base thinned-out by exemptions and widespread tax evasion.
- Scope for revenue increases without raising statutory rates via:
  - Expansion of the taxpayer net.
  - Lifting of exemptions.
  - Stepped-up tax administration and compliance.
- Historical experience:
  - During 1993-2001, India increased AETRs on labor and capital despite reductions in statutory rates and continued widespread exemptions, implying improved tax administration and compliance were key.

### Burden of taxation on investors — METW and METR findings
- Two indicators used: marginal effective tax wedge (METW) and marginal effective tax rate (METR).
- METW findings:
  - Marginal tax wedge in India is 1.4 percent (slightly below the OECD average).
  - Standard deviation of the marginal tax wedge across investment assets is three times higher than the OECD average — inventory investment is taxed more harshly than machinery and buildings.
  - FIFO inventory valuation raises tax burden by taxing inflationary gains in inventories.
  - Standard deviation of the marginal tax wedge across financing sources is nearly twice the OECD average.
  - Debt financing yields a negative tax wedge (a government subsidy for marginal debt-financed investments).
  - Investments financed by new equity face a below-average tax wedge; investments financed by retained earnings face a tax wedge in excess of 2½ percent (OECD average: 2 percent).
- Consequences:
  - Firms relying on internal financing are particularly penalized.
  - The relative tax advantage of debt finance may have contributed to relatively high financial leverage.
- Leverage statistics:
  - Average debt-to-equity ratio for Indian companies rose to 1.4 in 2002 from a low of 1.2 in 1996.
- METR findings:
  - METR for investments financed by retained earnings or equity is nearly 33 percent, compared to the OECD average of 22 percent.
- Sectoral and regional variation:
  - Firms benefiting from corporate tax exemptions face a marginal tax wedge of 0.4 percent, one full percentage point lower than firms without tax holidays.
  - Accelerated depreciation and other incentives lower the marginal tax burden for benefiting firms, producing large variations in METWs and allocative distortions.

### Priorities for reforms and assessment of the FRBMA road map
- Reform strategy advocated:
  - Combine lower statutory rates with base broadening to achieve pro-growth fiscal adjustment.
  - Remove exemptions and improve tax administration and compliance to raise direct tax revenue without higher statutory rates.
  - Lower statutory rates further to enhance neutrality and returns of the tax system.
  - Introduce a national VAT (GST) on goods and services to improve revenue productivity of domestic indirect taxes and recoup expected trade revenue losses; enhance economic efficiency.
- FRBMA road map tax proposals (government’s 2004 road map):
  - Direct tax measures proposed:
    - Reduce CIT rate to 30 percent and eliminate the surcharge.
    - Reduce the general depreciation rate to 15 percent.
    - Eliminate the withholding tax on distribution of dividends.
    - Eliminate the long-term capital gains tax.
    - Several measures (reduction in CIT and depreciation rates, elimination of long-term capital gains tax) have been implemented over the last two years; remaining measures in the 2006/07 budget would help consolidate gains.
  - Indirect tax measures proposed:
    - Introduce the GST to replace state VAT, CST, central excise duties, and central service tax.
    - Further reduce customs duties to levels in ASEAN member countries; tariffs have already dropped in the last two budgets with further cuts envisaged.
  - Tax productivity and administration measures:
    - Remove most exemptions and incentives; expand the taxpayer net.
    - Increase reliance on information technology: computerization of tax administration, increased withholding at source, a tax information network and tax information system to track interstate transactions, and computerization of customs.
    - Planned introduction of large taxpayer units in major cities in 2006 to reduce compliance and transaction costs for large taxpayers.
- Implementation caveats:
  - Most exemptions remain in place despite government announcements; some sunset clauses extended and new incentives introduced (e.g., 2005 Special Economic Zones Act).
  - New services have been added to the tax net over the last two years, but moving toward a GST requires further expansion of the service tax base and removal of most excise exemptions, including for small-scale industries and selected areas.
- Expected impact:
  - Implementation of remaining tax reforms would further decrease the marginal tax burden on investment and reduce tax-induced distortions; the METW would decrease further.

*Source: Box 3, Kelkar 2002 Reports’ Proposals — IMF staff compilation from the cited IMF working paper content.*

### 1.2 percent, thanks to lower personal taxes (Table 6). Neutrality with respect to sources of

### _wp0693 - 1.2 percent, thanks to lower personal taxes (Table 6). Neutrality with respect to sources of

### Neutrality of the tax system and corporate financing
- Reform would raise overall neutrality, but firms relying on internal financing (mainly smaller firms) would remain relatively penalized.
- The marginal tax wedge faced by firms relying on internal finance would remain ¼ percentage point above the OECD average.
- The standard deviation of the METW across investment assets would remain more than double the OECD average, indicating scope for further improvements.
- Policy measures to mitigate excessive reliance on debt finance and improve neutrality include:
  - Limiting deductibility of interest to a percentage of net taxable income.
  - Limiting debt for the purposes of income tax (examples cited: Canada limited to 2; Germany to 1.5; Japan to 3).
  - Limiting interest deductible to a referential rate (example cited: Portugal, the 12-month Euribor plus 1.5 percent).
  - Introducing an allowance for corporate equity.
- Footnote examples of equity-related measures: the notional rate of return on invested equity is deductible under the CIT in Croatia (1994–2001), and imputed equity return is taxed at a reduced rate in Austria and Italy (until 2001).

### Introduction of a state VAT and move to GST
- The recent introduction of a state VAT is described as a major step toward the GST.
- A GST at the national level should:
  - Allow full integration of goods and services taxation at the national level.
  - Help secure further gains in economic efficiency, with favorable effects on investment and exports.
- Preconditions and implementation challenges:
  - Bringing remaining states into the VAT.
  - Phasing-out the CST.
  - Reaching agreement with states on the sharing of GST revenues.
- Constitutional constraint noted: the Indian constitution currently gives the center the exclusive right to tax services, while precluding it from taxing sales; to introduce the GST a “grand bargain” is necessary whereby states agree to let the center tax sales in exchange for a share of GST revenues.
- A truly destination-based GST would:
  - Harmonize tax rates across states.
  - Allow the emergence of a single Indian market.
  - Greatly enhance India’s attractiveness as an investment destination.

### Base-broadening, projected revenue and tax productivity gains
- Base-broadening measures in the road map would imply significant increases in tax productivity and economic efficiency by reducing tax-induced distortions.
- Corporate tax revenue projection:
  - Corporate tax revenue is projected to nearly double from 2.3 percent of GDP in 2003/04 to 4.2 percent of GDP by 2008/09, despite a lower CIT rate, as most exemptions are eliminated.
- CIT tax productivity:
  - CIT tax productivity would more than double to 14 percent by 2008/09 (nearing the non-OECD average).
- Removal of most tax incentives would reduce variation of marginal tax burden across sectors and regions, contributing to higher economic efficiency.
- Proposed GST with few exemptions should enhance indirect tax productivity and improve economic efficiency.

### Table 6: Tax Wedges under Current vs. Reformed Tax System — selected indicators (as reported)
- Corporate tax revenue: 2.3 percent of GDP in 2003/04 → 4.2 percent of GDP by 2008/09.
- CIT tax productivity: projected to reach 14 percent by 2008/09.
- The table reports marginal effective tax rates (METW) and standard deviations across investment assets; the standard deviation measures neutrality of the tax system with respect to corporate financing and investment decisions—the lower the standard deviation, the more neutral the tax system.
- Specific METW and AETR figures in tabular form are reported in the source (see Table 6 entries and italics for corresponding marginal effective tax rates).

### Average Effective Tax Rates (AETRs) — methodology and alternatives
- AETR on labor:
  - Step 1: Effective tax rate on total household income = ratio of individual income tax to household income (including operating surplus of unincorporated enterprises (OSPUE), property income (PEI), and wage income (CE)).
  - Step 2: AETR on labor = (taxes paid on labor income—tax on wages and salaries calculated by applying the household income AETR to wage income—plus social security contributions and other payroll taxes) divided by (wages and salaries plus employer-paid social security contributions).
- AETR on capital:
  - Obtained by dividing the sum of taxes paid by capital (corporate income tax, household taxes on capital income, and various property taxes) by the net operating surplus of the economy.
- AETR on consumption:
  - Calculated as the sum of domestic taxes on goods and services, export, and import duties divided by the sum of private and government nonwage consumption, net of indirect taxes.
  - Indirect taxes are excluded in the denominator to express indirect tax rates as a percentage of the price before tax (Mendoza et al., 1994 approach).
- Alternative (revised) approach:
  - Recent studies argue for expressing the consumption tax base in gross terms (including indirect taxes in the denominator) to improve comparability with tax ratios on labor and capital and to facilitate calculating a combined AETR on labor and consumption (Carey and Rabesona, 2002). The source presents this alternative estimate alongside the original Mendoza et al. (1994) estimate.
- Assumption noted: Labor and capital income of households are assumed to be taxed at the same rate.

### Tax parameter data (December 2005) — key rates and parameters (In percent)
A. Corporate Tax System
- Corporate tax rate on retained earnings: 33.66
- Inventory valuation: FIFO
- Long-term capital gains tax rate: 0
- Dividend distribution tax rate: 12.75

B. Personal Tax System
- Interest income tax rate: 10.71
- Dividend income tax rate: 0
- Short-term capital gains tax rate: 10.2
- Long-term capital gains tax rate: 0
- Proportion of assets realized each period: 10

C. Tax Depreciation Rates
- Machinery: Depreciation method = Declining balance; Rate for declining balance = 15
- Buildings: Depreciation method = Declining balance; Rate for declining balance = 10

*Source: IMF staff estimates; text and tables as provided in the original content.*

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