Source: Ideas and Institutions Issue #3
Analysis
A Big Picture View of Income Tax Disputes in India
We, in India, routinely read or hear about raids conducted by income tax authorities on high-profile individuals or businesses. These raids often lead to attachment of property and the alleged discovery of undisclosed incomes. While the raids make for sensational headlines, it is important to consider the big picture on the relations between the state and taxpayers.
In her speech presenting the budget for 2019-20, Finance Minister Nirmala Sitharaman invoked the Tamil Sangam era poet Pisiranthaiyar’s allegory for government-taxpayer relations, “a few mounds of rice from paddy, that is harvested from a small piece of land, would suffice for an elephant. But what if the elephant itself enters the field and starts eating? What it eats would be far lesser than what it would trample over.”
Arguably for more than a decade, the elephant has been rampaging in the field because its appetite remains unfulfilled. Some of these years have been times of poor harvest. What’s more, hardly any of the crops the elephant takes after entering the field actually make it to its stomach.
An imaginative mind might see the shape of an agitated elephant in the following graph, which plots direct tax collection under dispute, at the end of a year, as a percentage of the gross direct tax collection during that year. The year-on-year change reflects the net change during the year, as some disputes get resolved, while others get instituted.
At the beginning of the previous decade, the disputes started rising rapidly, moderating slightly in 2016-17 and 2017-18, probably due to the amnesty schemes, which also suggested a thaw in state-capital relations. But in 2018-19 and 2019-20, the elephant raised its trunk in hunger and anger. To make matters worse, in 2020-21, low revenue receipts, a rise in disputes, and the slow resolution of disputes pushed the stock of direct tax collection under dispute to a level higher than the flow of direct tax revenues in the year. The spike in the early 2010s was mostly on account of disputes in personal income tax, but the recent spike is due to a rise in disputes in both corporate tax and personal income tax.
Disputes are not necessarily indicative of problems in tax administration. Rapidly changing economic activities lead to differences in how tax laws are interpreted. For instance, an increase in the presence of multinational corporations has created disputes around base erosion and profit shifting. Disputes could also rise due to changes in tax laws that take time to settle. What makes this rise in disputes a troubling indicator for tax administration is that the administration is usually unsuccessful in winning these disputes when they reach the courts.
The average percentage of cases resolved in favor of the tax administration – that is, cases in which the administration was successful in more than fifty percent of the issues contested - in the jurisdictions that reported for OECD’s biannual report on tax administration, was 66 percent in 2015, and more than 70 percent in 2016 and 2017. In India, this was in 11.5 percent in 2015, 12.1 percent in 2016, and 13.5 percent in 2017. This data was not reported for India in the latest edition, which covers the years 2018 and 2019.
While the poor success rate could partly be explained by a failure to fight these disputes properly, the sheer rarity of success suggests that the tax administration is making many unreasonable demands from the taxpayers. It is worth considering why this may be happening, and what could be done to address this problem.
Four aspects of the context could help in understanding the rise in disputes and the low success rate.
First, the rise in disputes corresponds with periods of crisis or slowdown in the economy. Early in the 2010s, the direct tax disputes increased while the economy was registering a fledgling, stimulus-driven recovery from the global financial crisis. The recent rise in disputes also corresponds with a growth slowdown. The economic problems may have translated into low tax collection. Perhaps the tax authorities, under pressure to deliver the revenue targets, made unreasonable demands; these demands later turn into disputes, leading to many demands being overturned. Even as the economy slowed between 2016-17 and 2019-20 and collection of indirect taxes was falling, direct tax receipts were rising, though they fell mildly in 2019-20, on account of a cut in corporate tax rates.
Second, the rise in disputes also corresponds with diluting checks and balances in the law that constrains the actions of revenue authorities. In 2017, major changes were made to the income tax law to weaken the checks on tax authorities. These include not requiring tax authorities to disclose the reasons for conducting or expanding searches and seizures, even to the appellate tribunal; empowering the officer conducting the search and seizure to attach property for a period of up to six months, with the prior approval of senior officers; reducing the seniority level of the officer who can call for information for any inquiry or proceeding; and so on.
Third, the fiscal context may also accentuate the pressure for making unreasonable tax demands. The government has large, committed expenditures but has, in most years since the global financial crisis of 2008-09, achieved weak performance in collecting indirect taxes, non-tax revenues (for example, dividends and spectrum auction), and non-debt capital receipts (primarily, disinvestment receipts). In recent years, a large increase in states’ share of union government’s tax collection motivated the latter to pursue a variety of tactics for increasing revenues. There also seems to be an unwillingness to increase indirect taxes, except through duties on petroleum products, depending on the crude oil prices. It is also administratively easier to make additional demands for direct taxes than for other forms of revenue receipts.
Finally, the rhetoric of political leadership in the last few years suggests that political leaders believe there is large scale tax evasion going on. The motivation for such rhetoric is complex, and this is not the place to analyze it. However, the rhetoric might have translated into political pressure on the tax administration to appear to be going after tax evasion. In 2019, additional assessments raised from audits corresponded to 41 percent of tax collections, while the average for the 50 countries included in an OECD report was just 5.5 percent. More than half of the corporate income tax collection, and about 28 percent of personal income tax, corresponded to additional assessments raised from audits.
The economic survey of 2015-16 found that India’s direct tax collection is consistent with other countries at this level of income. India’s personal income tax collection is much higher than the average for countries at its per capita income. So, the expectation from direct taxes might be built on false assumptions. This may be leading to unreasonable expectations from the tax administration, which delivers in the short run but later loses in disputes. So, the high contribution of additional assessments and the low success rate in disputes might be two sides of the same coin.
In a conversation on taxation, a former finance minister of India told me that from his perspective, tax buoyancy was a function of how many meetings he held at regional offices of tax authorities and how sternly he expressed himself in those meetings. In other words, he saw buoyancy as a function of political pressure on the administration. He also saw the perils of putting too much pressure.
The allegory of the elephant and farmer needs to be modified to include a mahout riding the elephant. When and how to exercise the power of the elephant to enter the field is a matter of the mahout’s practical wisdom in understanding what is in the elephant’s (and the mahout’s) long-term interest.
If the state goes too easy, rational actors may take advantage of it, but if it becomes too draconian, it could have a chilling effect on economic activity. Powers of tax authorities are the sword of Damocles dangling on all individuals and enterprises. They can disrupt businesses and harm personal reputations, and eventually they can also hurt the government’s ability to mobilize resources.
In recent years, the government has been trying to reduce the disputes. Its efforts have mostly been in the form of dispute settlement schemes that involve payment of taxes and, depending on the type of case, penalty by the taxpayer. Even when the appeal is filed by the department, the taxpayer must pay some taxes, albeit lower than the original claim. It seems that only those who expect to lose the case, or those for whom the cost of litigation does not justify continuing the dispute, would have the incentive to settle. Reports suggest that the latest scheme has addressed about five percent of direct tax collection under dispute.
In an important move signaling the political feasibility of other such moves, the government recently changed its stand on the retrospective tax cases. Perhaps things will get better going forward.
Here are three questions for you, dear reader:
- Is the government’s revenue mobilization strategy and its approach to administration of direct tax consistent with India’s investment and growth ambitions?
- Going forward, how can the tax administration’s incentives be structured so that unnecessary disputes do not arise?
- How can mechanisms such as advance ruling be used more actively to avoid future disputes?
—By Suyash Rai
Review
James C. Scott’s Searing Critique of State Power
The Covid-19 pandemic has, as some have argued, decisively led to the return of the state, thereby marking an end to the laissez-faire liberal order that earlier characterized nation-states. In India, the task of state-building has continued deterministically. The Indian state is expanding and becoming more capable. In this context, James C. Scott provides an insightful perspective on the nature of states and the dangers posed by an over-reaching state.
In much of his work, Scott provides a compelling account of how the state looks at society, the motivations for the state’s drive to increase its powers, and the pathologies and tragedies that sometimes result from these.
In Seeing Like a State (1998), Scott explains episodes where radical state action has led to human tragedy. Four elements are essential for such episodes to occur:
- The administrative re-ordering of society: This reordering consists of making sense of the world from the lens of the state, or of making certain characteristics of nature and human society ‘legible’ to the state. Scott highlights how states measure only certain aspects of nature and social existence that enable standardization and greater control. This is particularly pervasive in a modern state where the positive goals of statecraft require a greater knowledge of society, Aadhaar, for example, is a tool that creates a mechanism by which residents become legible to the Indian state.
- A high-modernist ideology: High-modernist ideology, according to Scott, is a way of thinking that is “unscientifically optimistic about the possibilities for the comprehensive planning of human settlement and production.” High-modernism has been common to both the left and the right—Communism as well as Nazism—and promotes the application of scientific rationality to engineer societies to suit ideological goals. Visually disorderly cities, for example, are thought to be inefficient. The high-modernist alternative was to have cities planned in miniature, with clear segregation of land-use and spatial designs marked by geometric proportionality.
- An authoritarian state willing and able to use coercive power to implement high-modernist ideology: The same ideology has also informed more tragic episodes in the 20th century, like the forced collectivization of agriculture in the USSR and China, and the Nazi Holocaust. The extreme left and right both believed that scientific, rational principles could be applied forcefully to their populations to re-order society.
- A prostrate civil society: The city of Brasilia (Brazil) was designed as a testament to high-modernist values, but its implementation was only possible because it was built as an entirely new city.
The combination of all these elements, as Scott convincingly argues, leads to not just human tragedy, but also to abject failure in achieving the original goals of state activity. Forced collectivization failed in enhancing agricultural production. The planned city of Brasilia saw slower rates of growth than the unplanned, informal city that came up next to it. The only successful outcome of such projects has been the larger degree of control that the state has exercised over society after the project was executed.
For these reasons, Scott looks at the state through an ‘anarchist squint’. Even though, according to Scott, this tendency towards high-modernism is largely a 20th century phenomenon, his later work hints at the fact that states have historically been largely coercive and brutal, and that modern states may, in fact, be relatively more humane.
In Against the Grain (2017), Scott relies on new findings in archaeology, anthropology, and ancient history to present a contrarian argument for how early states came into being. According to him, most of early statecraft centered around “collecting people, settling them close to the core of power, holding them there, and having them produce a surplus in excess of their own needs.” The early states’ functioning was mainly expropriatory, and such states may not have survived but for the use of severe coercion to force their populations to produce surplus for the political elite.
Scott speculates, based on recent evidence, that a large degree of state-building was accomplished only through extensive reliance on slavery. For this reason, his sympathies lie with the “barbarians” or the outsiders, the groups who managed to stay away from the yoke of the early “civilizing” state.
In contemporary times, Scott’s anarchist squint leads to similar support for the petit bourgeoisie—the peasant and the small entrepreneur. He argues in Two Cheers for Anarchism (2012), that in an era of large private and public bureaucracies, this class represents a zone of autonomy and freedom. This zeal for autonomy and freedom makes this class a critical moderating force against radical change.
This focus, on individual and group resistance to top-down social change by small entrepreneurs and peasants, is a key contribution by Scott to political science literature. In addition, his framework for understanding the excesses of state power and the consequences of high-modernist schemes, proves to be useful for understanding, and possibly moderating, such excesses.
—By Anirudh Burman