Tax Policy and Informality in South Asia and India

assumption is validated by showing parallel trends across treated and untreated firms in the months before the tax cut.

The study finds that, on average, assigning a product to a lower tax bracket reduces its ETR by a bit under 2 percentage points, leading to an increase in reported sales of 4 percent. These impacts translate into a precisely estimated elasticity of sales to the tax rate of −2.6, meaning that, as the ETR declines by 1 percentage point, firms report a 2.6 percent rise in sales. This represents a large elasticity with direct implications for the level of the tax rate that the government should consider. The simple Laffer curve argument states that any tax rate above a top rate is suboptimal because the government could collect more revenue by lowering the tax rate, and the resulting expansion in the base would compensate for the rate reduction. The elasticity estimate of the analysis puts this top rate at 27 percent to 28 percent, close to the top rate in the GST schedule. Understanding to what extent this large elasticity is driven by changes in demand, changes in reporting, or relabeling of products across categories is beyond the scope of the current paper, but it matters for the welfare impact of tax policy.

The study then investigates how elasticities correlate with the informal market share of a sector. To measure informal market shares across sectors, the analysis combines two surveys—the Annual Survey of Industries (ASI), conducted by the Ministry of Statistics and Program Implementation, and the Unorganized Manufacturing Enterprises Survey (UME), conducted by the National Sample Survey Organization as a part of the 62nd round of the National Sample Survey during July 2005–June 2006. The analysis finds that, together, they provide a plausibly representative picture of Indian manufacturing firms.1 Firms are classified in the ASI as formal if they report that they make value added tax (VAT) payments, while firms in the UME are, by construction, assumed to be informal.

With these data, the analysis correlates the sector-specific elasticities to the formal market shares of each sector. It finds that sectors with high elasticities are more and not less formal. This result invalidates the hypothesis that the sales of formal firms are more elastic in sectors exhibiting more intensive competition from the informal sector; this finding could be because informal and formal firms operate in segmented markets and are not in direct competition. Thus, no efficiency rationale exists for applying lower tax rates to products sold by formal firms in sectors with high informality.

CONTEXT

Low revenue collection is a perennial issue in the South Asia region. India collects only 12 percent of its GDP in taxes, a level analogous to its neighbors—Bangladesh 8.8 percent, Pakistan 11.8 percent, Sri Lanka 11.6 percent—and substantially below the level in countries in other parts of the world with similar incomes. The low revenue collection limits the provision of public goods and social insurance and the potential of redistribution. The narrow tax base of direct taxes (personal income and corporate

income taxes) is a key driver of the low tax revenue collection in South Asia. For example, in India, only 3 percent of the population pays the personal income tax; the share is about 1 percent in Bangladesh, Nepal, and Pakistan (Gupta 2015). As a result, indirect taxes account for a large share of revenue collection. On average, in the region, 46 percent of tax revenue is collected through taxes on goods and services.2 However, exemptions and rate differentiation are common and can erode the tax base and reduce revenue collection. The agriculture sector, self-employment, and small-scale family firms represent a large share of activity in South Asia and are inherently difficult to tax whether through direct or indirect taxes.

Most South Asian countries in recent years have expanded the tax base, simplified and strengthened tax administration, and initiated reforms of indirect taxes, such as the adoption of broader-based VATs. Adopting a single consumption tax rate for all goods and services limits the scope for tax evasion and tax avoidance and is optimal if redistribution can be achieved through income taxes and transfers. However, given the narrow base, the income tax only performs a limited redistributive role in South Asia; consumption taxes are thus often designed with multiple rates, depending on the products. Relative to the standard rate, necessity goods face lower rates, and luxury goods face higher rates. For example, Bangladesh and Sri Lanka have a reduced rate, a zero rate, and a tax-exempt category, in addition to the standard rate of 15 percent. The tax regime with the most rates across products is India’s GST.

CONSUMPTION TAX REFORM IN INDIA: THE GOODS AND SERVICES TAX

The GST is the main indirect tax applicable to the consumption of goods and services. It operates like a tax on value added. It was introduced across India on July 1, 2017, and it replaced all indirect taxes (except international customs duties) at central and state levels that had applied previously (that is, the central excise duty, service tax, VAT, luxury tax, other sales taxes). It transformed indirect taxes from source-based taxes into destination-based taxes. All state GSTs collected ordinarily accrues to the state where the consumer of the goods or services sold resides. The GST introduction is seen as one of the most important tax reforms of past decades. It is aimed at eliminating the cascading effect of taxes, especially in interstate trade (taxes levied on a product at every step of the sale), simplifying tax filing and registration thanks to the online GST Network platform, and reducing the burden of regulatory compliance. When GST was introduced, GSTN was a separate website for firms to submit their tax returns; the GST council is a separate entity that is a one-stop shop for all the laws and rules associated with GST, in addition to records of recommendation of GST revisions since 2017.

Despite the objective to simplify and unify tax rates, the GST maintained the multiplerate design that had previously existed in most states. Multiple rates tend to improve the equity of the tax system. Necessities are taxed at a lower rate, and luxuries at a higher rate. The GST was introduced with rates ranging from 5 percent to 28 percent; specific goods and services (such as fresh produce) were eligible for a 0 percent rate.

Some categories of luxury goods and services, such as vehicles, coal, tobacco, and aerated beverages, also face an excise tax known as the compensation cess.3 The current modal tax rate is the 18 percent tax bracket, although many items are subject to reduced rates and fall under the 0 percent, 5 percent, or 12 percent tax bracket. The 28 percent tax bracket for luxuries initially covered many products, which were eventually reclassified at lower brackets.

All decisions on the design of the GST—including the assignment of products to tax brackets, tax exemptions, and tax return filing rules—are made by the GST Council. The council is chaired by the union finance minister and is completed by the finance ministers of each state. The council usually meets every month. The council meetings in November 2017, January 2018, July 2018, December 2018, and February 2019 led to multiple changes in product tax rates. The principal motivation was that the initial rates were deemed to be too high. Over the first two years of the GST’s existence, many products were reclassified from the 28 percent tax rate to the 18 percent rate and from the 18 percent rate to the 12 percent rate.

INFORMALITY IN INDIA

A large share of India’s economy operates in the informal sector. Salapaka (2019) estimates that the informal economy accounts for roughly 50 percent of India’s GDP and 80 percent to 90 percent of employment in India. Firms in the informal sector are typically not registered with government authorities and do not remit taxes. Accordingly, the firms observed in the data are thus, by definition, not part of the informal sector. Yet, the existence of a large informal sector has implications for how formal firms respond to tax rates.

Formal firms that operate in sectors characterized by large informality may react to tax rate increases differently than firms operating in mostly formal industries. Competition with informal firms may make formal firms more willing to underreport their tax liabilities (that is, the intensive margin of tax evasion), to keep their costs low and to react to changes in tax rates. Moreover, the type of industries in which it is easier for firms to operate informally—such as industries with only small firms or with low capital requirements—may also be the type of industries in which formal firms find it easier to hide part of their production from tax authorities.4 This is more true, the higher the tax rate. Accordingly, there are reasons to believe that firms will respond more actively to changes in tax rates in industries characterized by widespread informality. This would have stark implications for policy: the higher the ETI, the higher the efficiency cost of taxation and the lower the optimal level of taxation. From an efficiency perspective, a finding that higher elasticities exist in industries with large informal sectors would suggest that these sectors should be taxed at a lower rate.

However, the correlation between the size of the informal sector and the elasticity across industries might go in the other direction if, for example, firms that operate