In our , we had argued that taxation is the economic glue that binds citizens to the state in a necessary two-way relationship. A citizen’s stake in exercising accountability diminishes if he or she 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%) 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?

Direct Taxation

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 highly 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 bodiesÌý(ULBs), 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 ULBs, fearing a loss of political control if ULBs 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 50-60% 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% of gross domestic product, about one-seventh of Brazil’s. ULBs account for about 2% 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 government tier 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 (councils) are unlikely to impose taxes on the very people who might control or constitute them.

Tax Decentralization

Thus, the 14th Finance Commission should take the lead and initiate the process of tax decentralization. It should do so not by fiat, but instead through the provision of incentives to states and local governments.

These incentives would take the form of the center 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 center 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.

Sustainable Democracy in India

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 center and other institutions to do so. One implication is this proposal should be implemented in a phased manner. For example, we could begin with municipal corporations, then municipalities and subsequently nagar panchayats (city councils) 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.

*[This article was originally published by .]

The views expressed in this article are the author’s own and do not necessarily reflect 51³Ô¹Ï’s editorial policy.

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How one-sided has India’s conversation on its government finances become. It is all about , spending, spending. For the (UPA) government, of course, elevated spending, subsidies and redistribution were sacred objectives. But the opening salvo of the great hope of Indian democracy, the (AAP), was to provide free water and power to the not-so-AAM citizens of Delhi, who already enjoy the highest living standards in India. Many of the (BJP) governments in the states have been trying to out-Congress the Congress on a range of subsidies.

The sobering fact is that at the next election, the three main choices on offer are: more of the same spending (Congress); more spending, less corruption (possibly) but also more economic nationalism (AAP); and no less spending, but possibly more market-based reform (BJP). And now, as if to confirm this obsession with spending, a proposal under serious consideration by the BJP would seek to eliminate income taxes altogether.

Revenue and Tax

We must be clear. In poor and unequal India, the level, type, quality and sustainability of spending are vital issues to debate. But the obsession with spending has crowded out discussions on spending’s Siamese twin: revenues and, more specifically, .

Of course, there have been major debates on taxation related to the reform of the (DTC), which would lower transaction costs and rent seeking in taxation; and to the implementation of the goods and services Ìý(), which would undoubtedly be a game-changer, boosting long-term economic growth, creating a common market within the country, increasing compliance, and raising aggregate revenues.

However, these debates have failed to address a central missing element, namely that if spending is about the entitlements of citizenship (at least loosely), taxation is its necessary twin: the obligations of citizenship. Taxation and military service (or some other form of compulsory national service) are two core elements of modern citizenship, with a shared identity or narrative being a possible third, as Isaiah Berlin suggested. Virtually all successful countries have had compulsory national service at some point in their histories, to emphasize the universality of obligations among a country’s citizens.

India has eschewed that path, leaving taxation as the only other obligation that it can demand of its citizens. The obligations of citizenship are the foundations of nation building and democracy. Unless India starts to focus on bringing more and more people into the tax net via some form of direct taxation, the promise of Indian democracy will remain unfulfilled.

What’s Democracy

Why do we say that? Democracy is a contract between the state and its citizens. And that contract has a vital economic dimension: the state’s part of the contract is to create the conditions for prosperity for all by providing essential services and also by protecting the less well-off via redistribution. The citizen’s part of the contract is to hold the state accountable when it fails to honor the contract.

But a citizen’s stake in exercising accountability diminishes if he does not pay in a visible and direct way for the services the state commits to providing. If citizens do not pay — through taxes or user fees — they either become free riders or exit, both of which reduce the accountability of the state. Hence the expression: no representation without taxation. Taxation is not just about financing spending, it is the economic glue that binds citizens to the state in a necessary two-way relationship.

Of course, there are many forms of taxation, but it appears that citizens feel the pinch of taxation most when their incomes or assets are taxed. Especially in a country like India, with limited levels of economic awareness and literacy, indirect taxes are not immediate or direct enough to be perceived by citizens as their contributions to the state.

For that reason, the implementation of the GST — while highly desirable and necessary — will have a limited impact in furthering the broader objective of citizen participation, state building, and democratic accountability. As evidence, economists Tim Besley and Torsten Persson show that countries with a higher share of income taxes in total tax collections tend to have more accountable governments.

How has India been faring in terms of bringing citizens into this participative process? According to detailed taxpayer data, in 2011-12, there were about 33 million individual tax assesses (that is, those who are in the tax net, although they may not all be paying taxes). Since some households will have more than one taxpayer, the total number of taxpaying households in India is about 25 million, assuming an average of 1.3 tax assesses per household. By this metric, 10% of Indian households pay income taxes. Assuming further that about half of all households in India are engaged in agriculture, which is out of the tax net, four out of five Indian households are not part of the income tax-government interaction.

In the absence of cross-country data, we cannot judge if this is a high or low number. But we can track India’s performance over time. In the graph above, we show the rate of growth of individual tax assesses (a measure of how fast citizens are being brought into the tax net), and compare that with the rate of economic growth.

The striking fact is that before the UPA came to power in 2004, tax assesses were growing on average at 16%, but between 2004-05 and 2011-12, they were growing at just under 2.5%. This major slippage that occurred is actually worse when one accounts for the fact that economic growth under the UPA was much faster than it was in the preceding years. We compute that in terms of this metric of tax performance, the UPA government was ten-times (or nearly 1,000%) worse than the previous government in increasing taxpayer participation.

To be fair, this government has been pushing hard to implement the GST but, as we argued earlier, that will not have the same impact on improving the quality of democracy. With such a small percentage of the population participating as , and with progress apparently decelerating, is it any wonder that public economics has become all about spending?

*[This article was originally published by .]

The views expressed in this article are the author’s own and do not necessarily reflect 51³Ô¹Ï’s editorial policy.

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