A Fiscal Tightrope, As Tax-GDP Ratio Rises, Tax Buoyancy Falls

The Union Budget for 2024-25, as presented in July last year after the General Election, estimated net direct tax collection at Rs 22.07 lakh crore. So, more than 12.6 per cent growth in the collection, compared to the actuals in the previous year, was expected.

However, the first advance estimates for 2024-25 have sent a dampening signal, by estimating real GDP growth at 6.4 per cent in 2024-25, compared to 8.2 per cent in the provisional GDP estimates for 2023-24.

Nominal GDP — the total value of all goods and services measured in current prices without adjusting for inflation during a specified period — has been estimated to grow at 9.7 per cent in 2024-25 over the growth rate of 9.6 per cent in 2023-24. This is proof enough of the presence of inflationary pressure in the economy.

As a result, net direct tax collection is also expected to fall. However, as a pleasant surprise, the actual net direct tax collection is likely to surpass last year’s Budget estimate by more than Rs 73,000-83,000 crore, according to latest Ministry estimates.

Top Bracket Individuals & Companies Earning More

During the economic recovery after the pandemic, net direct tax collection increased steadily. It jumped from Rs 14.12 lakh crore in 2021-22 to Rs 19.60 lakh crore in 2023-24.

The main reason for this jump was a similar increase in the growth rate of nominal GDP — as measured in national output at current prices. Nominal GDP grew by 19.3 per cent in 2021-22, followed by a healthy growth of 14.2 per cent and 9.6 per cent in 2022-23 and 2023-24, respectively.

However, as mentioned earlier, the nominal GDP is still set to rise 9.7 per cent in 2024-25 (as per first advance estimates). This rise in net direct tax collection in current rupee terms reflects the synchronisation of direct tax collection with the nominal GDP trend, at least partly.

There is no denying that ease of compliance and the use of technology in filing tax returns in recent years have contributed to the widening of the direct tax net. Similarly, rising direct tax collection, in absolute value, also partly reflects a rise in the income of individuals, at least for the upper end of the income distribution.

The advance tax payments by corporates, according to Ministry sources, have undergone over 16 per cent growth. So, in effect, the profit margins of top companies in the country are likely to go up, despite current public domain conversations on bottom-line pressures.

Twist In The Tale: Rising Tax-GDP & Falling Tax Buoyancy

The year-on-year net direct tax collection growth rate was 49.1 per cent in 2021-22, mainly due to the bounce-back from the previous, peak-pandemic year. The growth rate remained steady in the following two years at 17.8 per cent.

Underlining rising tax compliance in the last few years, the direct tax to GDP ratio also inched upwards to 6.64 in 2023-24, from 5.97 in 2021-22.

Even as direct tax collections show an upward trend, the costs of collecting taxes are also showing a downward trajectory, according to ministry sources. This is a piece of encouraging news, highlighting the deployment of technology in securing greater tax compliance and efficiency of the tax administration.

However, there is a bizarre twist to this overall positive fiscal tale. Even with a higher direct tax collection, the tax buoyancy is likely to diminish.

Tax buoyancy represents the responsiveness of tax revenues to changes in economic activity. In simple words, it is a measure of how tax revenues increase or decrease in response to the rise or fall in GDP, without altering the tax rates.

This tax buoyancy factor plunged to 1.25 in 2022-23, from a high of 2.54 in 2021-22. In 2023-24, it went up again to 1.86. However, it is set to diminish to a range between 1.68 and 1.73 in 2024-25, based on likely tax collections and GDP as projected in the first advance estimates.

Cautionary Fiscal Management Signals

A simultaneous decline in tax buoyancy and a rise in the tax-GDP ratio points towards a disconnect between economic growth and revenue generation. A decreasing tax buoyancy indicates that tax revenues are not growing as fast as the GDP growth. The point to be noted here is that nominal GDP is estimated to rise slightly, according to the first advance estimates.

Notwithstanding lower tax buoyancy, the rising tax-GDP ratio suggests that tax collection is growing faster than the overall economy.

Therefore, though tax collection goes up in the short run, a falling tax buoyancy signals potential long-term challenges in maintaining revenue growth in tandem with future economic expansion.

This phenomenon has significant fiscal management implications. While the economy shows short-term fiscal strength, there are alarming signals for the long-term sustainability of tax collections.

It may also be an indication of structural changes taking place in the economy, which could be sectoral or related to income distribution. In simple words, certain sectors or top-income bracket individuals or both may be contributing more to the tax collections than everybody else.

In such a situation, the government has to maintain a balance between robust tax collections and economic growth. While doing this, there is also a need to reassess the tax structure, so that it does not hamper economic growth while enhancing revenue streams.

So, the Finance Minister has her job cut out in this particular fiscal front in the upcoming Budget presentation.