Fiscal Policy Developments in India

1947 to 2007 •'

Incorporating

A Comprehensive Description and Review of Trends and Policies Pertaining toGovernment Budgeting, Taxation, Public Expenditure, Subsidies, Public Debt

and Fiscal Federalism in India

Appendices Containing Material on Indian Fiscal System

Glossary of Fiscal Terms

Time-series Public Finance Data on India

By

M.M. Sury

Indian Tax FoundationNew Delhi

in association with

NEW CENTURY PUBLICATIONSNEW DELHI, INDIA

Contents

Author's Note on the Book ix

Part I: Economic Role of the Government and Fiscal Policy

1. Economic Role of the Government and Fiscal Policy 1-141.1 Economic Responsibilities of the State

1.1.1 Views of Classical Economists1.1.2 Keynesian Economics and Compensatory Finance1.1.3 Limitations of Market Mechanism

A. Market Failure for Social Goods1.1.4 Special Economic Role of the State in Developing Countries

1.2 Modes of State Intervention1.2.1 Direct Intervention1.2.2 Indirect Intervention

A. Fiscal PolicyB. Monetary PolicyC. Industrial PolicyD. Commercial Policy

1.3 Fiscal Policy1.3.1 Resource Mobilisation1.3.2 Resource Allocation1.3.3 Distributive Justice

A. Determinants of Economic Power1.3.4 Stabilisation

1.4 Fiscal Policy-Monetary Policy Interaction

P a r t II: G o v e r n m e n t Budge t ing in Ind ia :Procedures and St ructure

2. Government Budgeting: Theoretical Settings 15-222.1 Significance of Government Budgeting2.2 Government Budgeting versus Private Budgeting2.3 Canons of Government Budgeting2.4 Zero-base Budgeting (ZBB)

2.4.1 Essential Elements of ZBB2.4.2 Limitations of ZBB

xvi Fiscal Policy Developments in India: 1947 to 2007

3. Government Budgeting in India: Constitutional Provisions andProcedures 23-463.1 Annual Financial Statement3.2 Accounts of the Government

3.2.1 Consolidated Fund of India3.2.2 Contingency Fund3.2.3 Public Account

3.3 Financial Emergency3.4 Phases of Budgetary Cycle

3.4.1 Preparation of the Budget3.4.2 Legalisation of the Budget

A. Presentation of the BudgetB. General DiscussionC. Demands for GrantsD. Appropriation BillE. Finance BillF. Supplementary Budget

3.4.3 Execution of the BudgetA. Maintenance of Accounts

3.4.4 Auditing of Accounts3.5 Performance Budgets3.6 Outcome Budget3.7 Other Supplementary Documents on the Budget

3.7.1 Medium-term Fiscal Policy Statement3.7.2 Fiscal Policy Strategy Statement3.7.3 Macro-economic Framework Statement

3.8 Parliamentary Control over the Budget ,3.8.1 Public Accounts Committee3.8.2 Estimates Committee3.8.3 Committee on Public Undertakings

4. Structure of the Central Government Budget 47-704.1 Revenue Budget

4.1.1 Revenue ReceiptsA. Tax RevenueB. Non-Tax Revenue

4.1.2 Revenue ExpenditureA. Revenue Non-Plan and Plan ExpenditureB. Functional Categories of Revenue Non-Plan Expenditure

Contents xvii

C. Major Items of Revenue Non-Plan Expenditure4.2 Capital Budget

4.2.1 Capital ReceiptsA. Market LoansB. Special DepositsC. External AssistanceD. Recovery of Loans and AdvancesE. Small SavingsF. Provident FundsG. Other Receipts

4.2.2 Capital ExpenditureA. Capital Non-Plan and Capital Plan ExpenditureB. Functional Categories of Capital Non-Plan Expenditure

4.3 Various Measures of Budget Deficit and Their Significance4.3.1 Overall Deficit (or Budgetary Deficit)

A. Treasury Bills Replaced by Ways and Means Advances (WMA)4.3.2 Fiscal Deficit4.3.3 Revenue Deficit .

A. Revenue Surplus Turned into Revenue Deficit4.3.4 Primary Deficit4.3.5 Monetised Deficit

4.4 Fiscal Responsibility and Budget Management Act (FRMBA), 20034.5 Deficit Financing: Magnitude and Timing4.6 Budget-Plan Integration4.7 Budget and the External Sector4.8 Budgetary Reforms Suggested by the Eleventh Finance Commission4.9 Budgetary Reforms Suggested by the Twelfth Finance Commission4.10 Budgetary Reforms Suggested by the Committee on Capital Account

Convertibility (Chairman: S.S. Tarapore), 2006

5. Functional, Economic and Cross-classification of the Budget 71-865.1 Functional Classification of the Budget

5.1.1 Uses and Limitations5.2 Economic Classification of the Budget since 1957-58

5.2.1 Meaning and Rationale5.3 Methodology of Economic Classification of the Budget

5.3.1 Derivation of Significant Economic AggregatesA. Total Expenditure of the GovernmentB. Final Outlays of the Government

xviii Fiscal Policy Developments in India: 1947 to 2007

C. Capital Formation Out of the Budgetary Resources of theGovernment

D. Net Capital Formation and Net Savings by the GovernmentE. Various Measures of Deficit in the Central

Government's Budgetary TransactionsF. Income Generation by the Government

5.3.2 Limitations of Economic Classification5.4 Cross-classification of the Budget since 1967-68

Par t III: Tax S t ruc ture Developments

Section A: Pre-Independence Tax System6. Pre-Independence Tax System 87-96

6.1 Taxes in Ancient India6.2 Taxes during Mughal Period6.3 Taxes during British Rule

Section B: Trends in Combined (Centre and States) Tax Revenues7. Constitutional Provisions Pertaining to Taxes 97-112

7.1 India: A Federal Polity7.2 Centrally Biased Constitution and its Justification

7.2.1 Supremacy of Union Legislative Power7.2.2 Union Control over State Legislation7.2.3 Emergency Provisions7.2.4 Restrictions on States' Taxation Powers7.2.5 Restrictions on the Borrowing Powers of the State Governments7.2.6 President's Rule

7.3 Constitutional Provisions Pertaining to Taxes7.3.1 Distribution of Taxation Powers7.3.2 Restrictions on the Taxation Powers of the States7.3.3 Rationale for Constitutional Arrangements7.3.4 Sharing of Central Taxes

, 7.3.5 Philosophy of Articles 268 and 269A. Duties under Article 268B. Taxes and Duties under Article 269

7.3.6 Taxes and Duties in the Union List not being Levied at PresentA. Entries 87 and 88B. Entry 89

Contents xix

C. Entry 90 ;

D. Entry 927.3.7 Freedom as to Payment of Taxes for Promotion of any

Particular Religion

8. Trends in Tax-GDP Ratio 113-1208.1 Tax-GDP Ratio: Meaning and Significance8.2 Determinants of Tax-GDP Ratio/Taxable Capacity

8.2.1 Stage of Development8.2.2 Composition of GDP8.2.3 Foreign Trade8.2.4 Composition of Government Expenditure8.2.5 Pattern of Income Distribution

8.3 Trends in Tax-GDP Ratio: Post-liberalisationSlippage and Recovery

8.4 Tax-GDP Ratios in Developed and Developing Countries8.4.1 Limitations of Inter-country Tax Comparisons

9. Direct and Indirect Taxes 121-1269.1 Direct versus Indirect Taxes: Theoretical Considerations9.2 Trends in the Relative Significance of Direct and

Indirect Taxes in India9.2.1 Reversal of Roles , .. .

9.3 Equity Implications

10. Buoyancy and Elasticity of Tax Revenue 127-13210.1 Conceptual Framework

10.1.1 Automatic Response versus Discretionary Changes10.1.2 Choice of Appropriate Base

10.2 Buoyancy and Elasticity Estimates of Tax Revenue in India

11. Distribution of Tax Burden (Tax Incidence) 133-15511.1 Meaning of Tax Incidence11.2 Methodological Issues11.3 All-India Level Studies

11.3.1 Findings of the Taxation Enquiry Commission(Chairman: John Matthai), 1953-54

11.3.2 Studies by the Ministry of Finance11.3.3 Estimates of Indirect Taxation Enquiry Committee

xx Fiscal Policy Developments in India: 1947 to 2007

(Chairman: L.K. Jha), 1978A. Critical Assessment

11.3.4 Findings of the Study by National Institute of PublicFinance and Policy (NIPFP)

11.4 State-Level Studies11.4.1 Orissa Taxation Enquiry Committee11.4.2 NCAER Study on Gujarat11.4.3 NCAER Study on Mysore (Now Karnataka)

! 1.5 Sectoral Studies

12. Tax Evasion: Magnitude, Causes and Remedial Measures 156-17412.1 Meaning of Tax Evasion

12.1.1 Tax Evasion and Tax Avoidance12.2 Devices Adopted to Evade Taxes

12.2.1 Income Tax12.2.2 Excise Duties12.2.3 Value-Added Tax12.2.4 Customs Duties

12.3 Causes of Tax Evasion12.3.1 Level of Tax Rates12.3.2 Attitude towards Government and its Laws12.3.3 Lenient Penal Action12.3.4 Nature of the Economy

12.4 Consequences of Tax Evasion12.5 Measures to Curb Tax Evasion

12.5.1 Lowering of Tax Rates12.5.2 Withholding Tax12.5.3 Presumptive Tax12.5.4 Tax Amnesties12.5.5 Computerisation

12.6 Various Estimates of Tax Evasion in India12.6.1 Taxation Enquiry Commission

(Chairman: John Matthai), 1953-5412.6.2 Nicholas Kaldor12.6.3 Central Board of Revenue12.6.4 Direct Taxes Enquiry Committee

(Chairman: K.N. Wanchoo), 197112.6.5 National Institute of Public Finance and Policy (NIPFP)12.6.6 Tax Reforms Committee (Chairman: Raja Chelliah), 1991

Contents xxi

12.7 Government's Policy to Curb Tax Evasion12.7.1 Lowering of Tax Rates12.7.2 Tax Amnesties

A. Voluntary Deposit Scheme, 1991B. Gold Bond Scheme, 1993C. Voluntary Disclosure of Income Scheme, 1997

12.7.3 Advance Tax Payment and Tax Deduction at Source12.7.4 Presumptive Tax12.7.5 PAN/GIR12.7.6 Survey of Income Tax12.7.7 Summons, Search, and Seizure

A. SummonsB. Search and Seizure

12.7.8 Purchase of Immovable PropertyA. Income Tax Clearance for PropertiesB. Pre-emptive Acquisition of Properties

12.7.9 Penalties and ProsecutionsA. PenaltiesB. ProsecutionsC. Penal Provisions: A Comment

12.8 Conclusion

Section C: Central Taxes13. Trends in Central Taxes 175-182

13.1 Central Taxes as Per Cent of GDP13.2 Direct and Indirect Taxes13.3 Composition of Direct Taxes

13.3.1 Income Tax13.3.2 Wealth Tax

13.4 Composition of Indirect Taxes13.4.1 Union Excise Duties13.4.2 Service Tax13.4.3 Customs Duties

14. Income Tax 183-23314.1 History of Indian Income Tax

14.1.1 Income Tax Act, 186014.1.2 Income Tax Act, 188614.1.3 Income Tax Act, 1918

xxii Fiscal Policy Developments in India: 1947 to 2007

14.1.4 Income Tax Act, 192214.1.5 Recommendations of the Indian Taxation Enquiry Committee

(Chairman: Charles Todhunter)," 1924-2514.1.6 Recommendations of the Income Tax Enquiry Committee, 1935

14.2 Constitutional Provisions and Legal Framework14.2.1 Constitutional Provisions

14.3 Revenue Significance of Income Tax14.4 Income Tax Act, 1961: Main Provisions

14.4.1 Meaning of Income14.4.2 Residential Status14.4.3 Incomes Exempt from Tax14.4.4 Tax Holiday Schemes

A. Tax Holiday for Newly Established Industrial Undertakings inFree Trade Zones, Electronic Hardware Technology Parks, orSoftware Technology Parks or Special Economic Zones

B. Tax Holiday for Newly Established 100 Per Cent Export-Oriented Undertakings

C. Tax Holiday for Exporters of Wood-based Handicraft Items14.4.5 Heads of Income

A. SalariesB. Income from House PropertyC. Profits and Gains of Business or ProfessionD. Capital GainsE. Income from Other Sources

14.4.6 Clubbing of Income14.4.7 Set Off and Carry Forward of Losses14.4.8 Deductions from Gross Total Income

A. Deductions in Respect of Certain PaymentsB. Deductions in Respect of Certain Incomes

14.4.9 Rebates14.4.10 Computation of Total Income14.4.11 Units of Assessment14.4.12 Basic Exemption14.4.13 Rate Structure

A. Surcharge14.4.14 Advance Payment of Tax14.4.15 Tax Deduction at Source

14.5 Taxation of Companies14.5.1 Main Features of Company Taxation

Contents xxiii

14.5.2 Compulsory Filing of Returns by Companies14.6 Taxation of Partnership Firms14.7 Tax Treatment of Small Traders (Presumptive Tax)14.8 One-by-Six Criteria Scheme14.9 Taxation of Capital Gains

14.9.1 Meaning and Scope of Capital Gains Tax14.9.2 Transactions Regarded as Transfer14.9.3 Year of Taxability14.9.4 Short-term versus Long-term Capital Gains14.9.5 Computation of Short-term Capital Gains14.9.6 Computation of Long-term Capital Gains

A. Inflation IndexingB. Certain Long-term Capital Gains Exempt from Tax

14.9.7 Capital Gains Account Scheme, 198814.9.8 Set Off and Carry Forward of Capital Losses14.9.9 A Critique

14.10 Recommendations of the Task Force on Direct Taxes(Chairman: Vijay Kelkar), 2002 Pertaining to Income,Tax14.10.1 Personal Income Tax14.10.2 Corporate Tax14.10.3 Capital Gains

14.11 Critical Evaluation of the Indian Income Tax System14.11.1 Unstable Law14.11.2 Multitude of Exemptions/Concessions14.11.3 Earned versus Unearned Incomes

15. Wealth Tax 234-24015.1 Rationale for Wealth Tax15.2 Wealth Tax Act, 1957: Main Provisions

15.2.1 Persons Chargeable to Wealth Tax15.2.2 Net Wealth and Residential Status15.2.3 Meaning of Net Wealth15.2.4 Meaning of Assets15.2.5 Deemed Assets15.2.6 Assets Exempt from Wealth Tax15.2.7 Basic Exemption and Rate of Tax

15.3 Critical Comments15.3.1 Shrinkage of Base15.3.2 Lowering of Top Marginal Rate

xxiv Fiscal Policy Developments in India: 1947 to 2007

16. Union Excise Duties 241-26816.1 Pre-Independence History of Excise Duties

16.1.1 Cotton Textiles16.1.2 Salt16.1.3 Petroleum Products16.1.4 Tobacco16.1.5 Other Products16.1.6 Rules of Excise Taxation

16.2 Constitutional Provisions16.3 Various Types of Excise Duties

16.3.1 Basic Excise Duty16.3.2 Additional Duties in Lieu of Sales Tax16.3.3 Cesses

16.4 Different Procedures to Collect Excises16.4.1 Physical Control System16.4.2 Self-Removal Procedure (SRP)16.4.3 Compounded Levy Scheme

16.5 New Excise Tariff Nomenclature16.6 Administration of Excise Taxation16.7 Revenue Significance16.8 Commodity Coverage16.9 Excise Tariff Structure

16.9.1 Statutory versus Effective Rates16.9.2 Specific versus Ad Valorem Duties16.9.3 Multiplicity of Excise Tariff16.9.4 Committee on Rationalisation and Simplification of the Tax

Structure (Chairman: S. Bhoothalingam), 196816.9.5 Indirect Taxation Enquiry Committee (L.K. Jha), 197816.9.6 Technical Study Group on Excise Tariff (Chairman: J. Dutta), 198516.9.7 Triple Rate Excise Structure16.9.8 Task Force on Indirect Taxes (Chairman: Vijay Kelkar), 2002

16.10 Excises on Inputs16.10.1 Pre-MODVAT Arrangements16.10.2 MOD VAT Scheme

A. FeaturesB. Advantages

16.10.3 Introduction of CENVAT16.10.4 Further Simplification

16.11 Exemptions and Concessions

Contents xxv

16.11.1 Rationale16.11.2 Problems Created by Concessions16.11.3 General Exemptions16.11.4 Concessions to Small Industries16.11.5 Misuse of Concessions

17. Taxation of Services 269-27617.1 Justification for Taxing Services17.2 Constitutional Provisions17.3 Growth of Service Sector in India17.4 Present Structure of Service Tax17.5 Conclusion

18. Customs Duties 277-29618.1 Introduction18.2 Pre-Independence History of Customs Duties

18.2.1 Period 1859 to 189418.2.2 Period 1894 to 191918.2.3 Inter-War Period18.2.4 Second World War

18.3 Legal Framework18.3.1 Various Types of Customs Duties

A. Basic Customs DutyB. Additional (Countervailing) Duty of CustomsC. Export DutyD. Cesses on Exports

18.4 New Customs Tariff Nomenclature18.5 Revenue Significance18.6 Import Tariff Policy

18.6.1 Early Post-Independence Period18.6.2 Customs Reorganisation Committee

(Chairman: F.C. Badhwar), 1957-5818.6.3 Indirect Taxation Enquiry Committee

(Chairman: L.K. Jha), 197818.6.4 Long-Term Fiscal Policy, 198518.6.5 Tax Reforms Committee (Chairman: Raja Chelliah), 1991

18.7 Post-liberalisation Reduction and Rationalisation of Import Tariff18.7.1 Off-budget Package of Tax Concessions, January 2004

18.8 Recent Thinking on Customs Tariff

xxvi Fiscal Policy Developments in India: 1947 to 2007

18.8.1 Customs Tariff Report (Chairman: Arvind Virmani), 200218.8.2 Import Duty Structure Recommended by Task Force on

Indirect Taxes (Chairman: Vijay Kelkar), 200218.9 Export Tariff Policy

Section D: State Taxes19. Trends in State Taxes 297-306

19.1 State Taxes as Per Cent of GDP19.2 Direct and Indirect Taxes

19.2.1 Composition of Direct TaxesA. Land RevenueB. Agricultural Income TaxC. Professions Tax

19.2.2 Composition of Indirect TaxesA. Sales TaxB. State ExcisesC. Taxes on Motor VehiclesD. Entertainment TaxE. Stamp Duty and Registration FeesF. Electricity DutyG. OctroiH. Land and Buildings

19.3 Local Finance

20. Taxation of Agricultural Income 307-31520.1 Constitutional Provisions20.2 Committee on Taxation of Agricultural Wealth and Income

(Chairman: K.N. Raj), 197220.2.1 Views of the State Governments

20.3 Tax Reforms Committee (Chairman: Raja Chelliah), 199120.4 Task Force on Direct Taxes (Chairman: Vijay Kelkar), 2002

20.4.1 Critical Comments

21. Sales Tax 316-34621.1 Different Forms of Sales Tax

21.1.1 Multi-point Sales Tax21.1.2 Single-point Sales Tax

21.2 Pre-Constitution Developments21.2.1 Initial Legal Hurdles

Contents xxvii

21.2.2 Beggar-my-neighbour Policies21.3 Constitution of India and the Provisions for the Regulation of

Taxation of Inter-State Sales21.3.1 Consequences of Constitutional Restrictions on

Sales Tax21.3.2 Essential Goods Act, 1952

21.4 Constitution (Sixth Amendment) Act, 195621.5 Central Sales Tax (CST) Act, 1956

21.5.1 Main Provisions of CST Act21.5.2 Working of CST Act

21.6 Additional Duties of Excise (Goods of Special Importance)Act, 195721.6.1 Rationale of the Scheme21.6.2 Views of the State Governments21.6.3 Decisions of the National Development Council (NDC)21.6.4 Expert Committee on Replacement of Sales Tax by

Additional Excise Duty (Chairman: Kamlapati Tripathi), 198321.7 Constitution (Forty-sixth Amendment) Act, 1982 and

Consignment Tax21.7.1 Issues Related to Consignment Tax

21.8 Present Nature of Sales Tax21.9 Problems Created by Sales Tax21.10 Alternative Remedies

21.10.1 Sales Tax as Central Levy21.10.2 Complete Substitution of Sales Tax by Excise Duty21.10.3 Partial Substitution of Sales Tax by Excise Duty21.10.4 Minimum Rate Agreement among States21.10.5 Single-Point VAT21.10.6 Agreement of November 199921.10.7 Empowered Committee of State Finance Ministers

(Chairman: Asim Kumar Dasgupta), 200121.10.8 Agreement of January 23, 200221.10.9 Task Force on Indirect Taxes

(Chairman: Vijay Kelkar), 200221.10.10 Agreement of June 200421.10.11 Salient Features of the State-level VAT Design21.10.12 Progress of VAT Implementation21.10.13 Towards National Goods and Services Tax (GST)

xxviii Fiscal Policy Developments in India: 1947 to 2007

Section E: International Aspects of Indian Taxation22. International Aspects of Indian Taxation (Double Taxation) 347-364

22.1 What is Double Taxation?22.1.1 Double Taxation by the Same Tax Jurisdiction22.1.2 Double Taxation by Competing Tax Jurisdictions at

Different Levels of Government in a Country22.1.3 Double Taxation by Competing Tax Jurisdictions at

Same Level of Government in Different Countries22.2 International Double Taxation22.3 Assignment Rules of Foreign Income

22.3.1 Source Rule22.3.2 Residence Rule

22.4 Methods to Alleviate International Double Taxation22.4.1 Exemption Method22.4.2 Foreign Tax Credit

A. Tax Sparing Credit22.4.3 Bilateral Tax Treaties22.4.4 Multilateral Tax Treaties

22.5 International Tax Avoidance and Evasion22.5.1 Transfer Pricing

A. Arm's Length Price22.5.2 Tax Havens22.5.3 Tax Treaty Shopping

22.6 Taxation of Non-residents in India22.6.1 Rules to Determine Residential Status

A. Residential Status of an IndividualB. Residential Status of a Company

22.6.2 Relationship between Residential Status and Tax IncidenceA. ResidentB. Not Ordinarily ResidentC. Non-resident

22.7 Indian Law on Double Tax Relief22.8 Tax Incentives for Non-Resident Indians22.9 Assessment and Collection of Tax from Non-Residents

Par t IV: Public Expendi tu re

23. Public Expenditure: Theoretical Overview 365-37623.1 Determinants of Public Expenditure