Budget 2019 must focus on diversifying sources of govt revenue; over-reliance on taxes is axing benefits of welfare schemes

Editor's Note: This article was first published on 21 January, 2019. It is being republished in the light of the 2019-20 Brihanmumbai Municipal Corporation budget which was presented by Commissioner Ajoy Mehta on Monday.

In the run-up to the Union Budget 2019-20, the focus of public opinion makers will once again be on deliberating the Central government’s fiscal health. The discourse is likely to be around the pattern and implications of growing expenditures. But the other half of the equation — revenues of the government — is equally critical for fulfilling the government’s mandate and needs closer scrutiny.

Usually, governments around the world have a wide array of revenue generating options at their disposal. However, the nature of the economy and administrative capacity may constrain, either by choice or compulsion, the government's revenue generating capacity. These constraints result in governments heavily relying on a few handles, often indirect in nature, which could create economic distortions and have serious welfare consequences.

Representational image. Reuters

Representational image. Reuters

Take the case of Hong Kong. It has been consistently ranked the freest economy in the world for the last 24 years. Free-market economic policy, as well as low corporate taxes, are enshrined into the fabric of the city, leading it to become a great place to invest and conduct business. This, however, implies that its revenue-generating options are limited and tend to be overused.

With less than 4 percent of Hong Kong’s built-up area zoned for residential housing, the government leases out land to developers for astronomical prices that helps generate almost 30 percent of its entire revenue. This has made Hong Kong among the least affordable housing markets in the world. Housing prices are almost 20 times greater than median household income and millions of people are forced to live in 'cage/coffin homes', houses less than the size of a single parking space.

A similar phenomenon is seen in India where direct tax collections remain extremely low and there is an overreliance on revenue from fuel sales. Central and state fuel taxes comprised between 30 percent to 40 percent of the retail price of fuel in 2018. Further, the standardised excise duty set by the centre has been increased nine times since 2014 while being reduced only once last year. On the other hand, state-apportioned sales tax/VAT is allocated ad-valorem, meaning that states inherently benefit with higher tax earnings when the price of fuel increases. Due to these factors, we have seen excise duty and sales taxes/VAT collections grow annually at rates of 22 percent and 11 percent, respectively, since 2011-12.

Furthermore, between states themselves, VAT on fuel ranges between 18 percent in Goa to 39 percent in Maharashtra showcasing that some states regard tax earnings from fuel as a major revenue handle as compared to others. This over-reliance on tax earnings from fuel has led to India being ranked the lowest in terms of affordability of petrol as buying a litre of fuel costs the citizen around 22 percent of their daily wages.

A similar story plays out at the third tier of government. With sources of revenue and functionaries bunching up at the top tier, each successive level of government has a declining mandate and capacity to raise revenue. Such a structure leads to lower levels of government excessively relying on alternate sources of revenue that create welfare loss. An example of this is the Municipal Corporation of Greater Mumbai (MCGM).

Despite governing the highest revenue-generating urban agglomeration in the country and having a large budget, its third-tier status in government hierarchy makes it rely on only a few revenue handles. Before its abolition, collection from octroi (duty levied on goods entering Mumbai) was the largest source of revenue for the urban local body.

The distortionary implications of octroi are well known.

While octroi was removed as a condition to the rollout of the Goods and Services Tax (GST) by the Central Government, the lost income from such duties threatened to create a huge gap between income and expenditures for the MCGM. Due to its low capacity to increase revenue from traditional sources, MCGM is now relying aggressively on another regressive policy of using land-based financing tools such as premium on Floor Space Index (FSI) and Transferable Development Rights (TDRs). These tools have become the highest revenue-generators for the urban local body.

In 2015-16, additional FSI and Fungible Compensatory FSI contributed over Rs 2,830 crores as against Rs 2,500 crores raised from property taxes. The over-reliance on this regressive policy has had the unintended consequence of further distorting real estate markets and adding to the unaffordability of housing in Mumbai.

We often see a lot of public attention given to the management of fiscal deficits and the expenditure side of a revenue-generating body. However, the components of its revenue portfolio are often overlooked. Bringing attention to, and addressing, this underlying problem, is crucial in order to improve welfare outcomes for citizens. Moreover, if governments do diversify their revenue portfolio, they would not only get insurance against unforeseen shocks to their leading revenue source but also obtain the policy space to adopt innovations that potentially axe such welfare-reducing policies.

(Munshi is Senior Associate and Pachisia, Senior Analyst, at IDFC Institute, a Mumbai-based public policy think tank.)

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Updated Date: Feb 05, 2019 08:43:23 IST

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