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Indexing the Effectiveness of Tax Administration

The capacity of the tax administration needs to be continuously augmented to keep pace with the changing requirements of tax policy. One of the key challenges in this respect is to measure the effectiveness of the tax administration. This paper develops an econometric model for indexing the effectiveness of tax administration by using the principal component method to remove the feedback effect between voluntary and enforced compliance. This model shows that there has not been a large change in the effectiveness of the direct tax administration in the country over a period of time, despite the fact that there has been a substantial increase in the quantum of direct tax revenue, particularly over the last few years. This calls for attention to strengthen the tax administration.

SPECIAL ARTICLEDecember 15, 2007 Economic & Political Weekly104The authors have benefited immensely from their discussions on the sub-ject with Amaresh Bagchi, and from the comments by Kalpana Kochhar, IMF on the draft paper. The error, if any however, is of the authors. Sanjay Kumar (s.kumar@nic.in) is an officer of the Indian Revenue Service; A L Nagar is a senior consultant, at the Tax ResearchCell,National Institute of Public Finance and Policy (NIPFP), New Delhi; Sayan Samanta is a project associate at NIPFP.Indexing the Effectiveness of Tax AdministrationSanjay Kumar, A L Nagar, Sayan SamantaThe capacity of the tax administration needs to be continuously augmented to keep pace with the changing requirements of tax policy. One of the key challenges in this respect is to measure the effectiveness of the tax administration. This paper develops an econometric model for indexing the effectiveness of tax administration by using the principal component method to remove the feedback effect between voluntary and enforced compliance. This model shows that there has not been a large change in the effectiveness of the direct tax administration in the country over a period of time, despite the fact that there has been a substantial increase in the quantum of direct tax revenue, particularly over the last few years. This calls for attention to strengthen the tax administration.Tax policy and tax administration are inextricably linked to each other.1 For the design of a successful tax policy due attention requires to be paid to removing administra-tive constraints. Tax reform figures prominently in India’s plans for fiscal consolidation. Successive governments have devoted considerable efforts to developing a tax reform strategy, which have broadly centred on bringing changes to the tax exemption level, tax rate structure, and broadening of the tax base [Rao and Rao 2005]. But despite these policy efforts, the average effective tax rate has remained low compared to advanced economies, and also to the higher-income emerging market countries in the region. The relatively low average effective tax rate in India is mainly due to low tax productivity, reflecting a thin tax base and widespread tax evasion. This suggests ample scope for increasing revenue (without raising tax rates), via expansion of the taxpayer net, lifting exemptions and stepped up tax administration [IMF 2006]. Improved tax administration and compliance often result in improvement in revenue productivity, and rise in the average effective tax rate.2 Improvement in tax administration seeks to secure maximum tax revenue effectively and efficiently given the tax rates. In an ideal situation, people would pay taxes they owe, and tax admini-stration would amount to no more than providing facilities for tax payments. But such situations do not exist. Effective tax ad-ministration requires an environment in which citizens are in-duced to comply with tax laws voluntarily. In fact, this is based on the incentive pattern. If they feel that the non-compliance may cost more, people would comply with tax laws more. But if the belief prevails that the cost of non-compliance is not likely to be high, evasion would be practised with impunity. Thus, the effec-tiveness of tax administration in fostering compliance would ulti-mately depend upon the perceived ability to detect and bring tax offenders, namely, unregistered taxpayers, stop filers, tax evad-ers, and delinquent taxpayers to book. The tax administration needs to deal with all these categories of taxpayers simultane-ously; otherwise non-compliance would shift to the gap where administration is weak. An efficient tax administration would, therefore, detect and penalise non-compliance, and facilitate vol-untary compliance through the provision of quality taxpayers’ service. Thus, taxpayers’ education and service, collection, colla-tion, storage, retrieval and verification of information, along with collection of taxes and grievance redressal systems create syner-gies for an efficient and effective tax administration. Some of these functions are for encouraging voluntary compliance, and some for enforcing compliance. Given their synergistic role in building an efficient tax administration, it becomes very difficult to segregate one from the other, and it also results in difficulty for
SPECIAL ARTICLEEconomic & Political Weekly December 15, 2007105the tax administration in assigning a role for its employees – tax enforcer or a tax facilitator. This paper examines the effectiveness of direct tax adminis-tration in India through an econometric model, taking into ac-count tax collections.3 It constructs a tax enforcement index treating enforcement as a latent variable through principal com-ponent analysis, and attempts policy recommendations for im-proving the efficiency and effectiveness of tax administration. The paper takes tax rates as given. It also does not attempt de-signing the tax administration; rather focuses only on the effec-tiveness of tax administration. Section 1 gives a brief description of the current position of the tax administration, and compares it tosomeothercountries’ tax administrations – developing and developed.Section 2 constructs the tax enforcement index. Section 3 attempts some key policy issues, which would bring a more effective and efficient tax administration. 1 Current Position of Tax AdministrationAs stated above, effectiveness of the tax administration would depend on its ability to detect and bring tax offenders to book. Some of the main areas of tax offences are un-registered taxpayers, stop filers, tax evaders, and delinquent taxpayers.1.1 StopFilersIn India, the stop filers are around 10 per cent.4 The figures (in percentage terms) in Table 1 give a comparative chart of the stop filers, ex-isting taxpayers and new taxpayers over the last five financial years. It may also be stated here that these fig-ures may not be entirely correct, because the permanent account number (PAN)5 database (particularly, for the personal income taxpay-ers) has not been very accurate. Most of the tax districts,6 till late, have been maintaining an individual database manually, and so, if any taxpayer shifted from one tax district to an-other, there was no mechanism to verify this, unless the taxpayer himself reported doing so. Otherwise, he would be reported as a stop filer in one district, and a new taxpayer in another. Besides this, a number of taxpayers had two or more PANs – out of volition or out of confusion. This also led to double counting. On the corporate taxpayer’s side, companies are mandatorily required to file returns of income as per the income tax laws.7 As on October 31, 2004, 6,61,371 companies were under registration in the country,8 but the records of the income tax department show that only 3,72,483 returns were filed. This shows that about 44 per cent of the companies did not file corpo-rate tax returns. While the reasons for high percentage of stop filers or inac-curacy of the data above may be debated, it is certainly true that there needs to be substantial improvement in order to develop an efficient tax administration. The reason that the taxpayers reg-ister is out of date highlights that the tax administration is not dealing with stop filing taxpayers in a systematic manner, and needs to design an adequate strategy. 1.2 DelinquentTaxpayers Priorities are often set for controlling delinquent taxpayers.9 Tax administrations normally have sufficient legal provisions avail-able to take swift and effective action against the delinquent taxes. Though many times such non-payments of taxes are not dueto lack of effort on the part of tax administration, they mayalso be for the reasons that the tax demands may be in dispute before the courts, which sometimes take an inordinately long-time to decide on the tax demands. Also, sometimes the taxpayers file appeals the court decisions and take the cover of the tax demand under dispute as the reason for not paying taxes. That apart, reasons such as raising infructuous demand due to lack of evi-dence, collusion between tax enforcers and taxpayers, double counting of the tax demand, etc, also cannot be ruled out. Whatever be the reason, delinquent taxes in India have shown a steady rise from Rs22,928crore in 1995-96 to Rs 98,612 crore in 2005-06, implying a compounded annual growth rate of 30 per cent. Compared to that, the percentage collection of these arrear demands have remained static between 8 and 9 per cent – the only rise was in the financial year 1999-2000 when the government intro-duced a scheme for settling tax arrears. These outstanding arrears, as can be seen, are almost equal to or a high percentage of the annual tax collections. The figures show that the arrear demand collection has remained flat over as a percent-age of the total collection during the last nine years, indicating that there has not been any perceptive change in the effort of the tax ad-ministration towards collecting arrears. But what needs to be realised is that often lax at-tention to tax delinquency can be an expen-sive source of financing for the government, and easy and cheap source of finance for the taxpayer. It is often seen that a small percentage of delinquent taxpayers account for a large per-centage of delinquent taxes. Statistics from Latin American countries show that 3 to 12 per cent of delinquent taxpayers accounted for 65 to 90 per cent of delinquent taxes. Such a pattern of high delinquent taxes being as-cribed to a small percentage of taxpayers alsoexistsinIndia.Quick estimates show that close to 80 per cent of the delinquent taxes involve only 200 taxpayers. Such high concentration of arrears in a few taxpayers requires a set of arrear collection priorities. Table 1: Comparing Stop Filers, Existing and New Taxpayers (in %)Year Stop Filers Existing New TaxpayersTaxpayers2000-01 12.31 71.91 15.782001-02 6.87 71.90 21.232002-03 17.70 77.46 4.842003-04 16.35 78.18 5.472004-05 3.39 89.62 6.99Source: Income tax department, government of India.Table 2: Arrear Demand Collection for Income and Corporate Tax(in Rs crore)Financial Arrear CashPercentage Year DemandBroughtCollectionCollection Forward as on Out of Arrear March31Demand1995-96 22,928.612,079.01 9.071996-97 29,221.492,328.41 7.971997-98 33,925.47 2,845.048.391998-99 45,039.953,049.476.771999-2000 43,868.78 30,066.60 68.542000-01 51,472.554,991.91 9.702001-02 49,222.85 3,938.898.002002-03 73,012.855,499.25 7.532003-04 72,347.885,540.23 7.662004-05 92,886.00 7,084.00 7.632005-06 98,612.008,064.00 8.18Source: CBDT.Table 3: Collection of Personal Income Tax (as % of total collection)Year Pre-assessmentPost-assessment CollectionCollection1995-96 82.6 17.41996-97 82.6 17.41997-98 85.6 14.41998-99 82.4 17.61999-2000 79.5 20.52000-01 83.1 16.92001-02 84.2 15.82002-03 87.7 12.32003-04 85.3 14.7Source: CBDT.
SPECIAL ARTICLEDecember 15, 2007 Economic & Political Weekly106Table 4: Matrix (R) of Correlations between Various Components of Income TaxComponents of IT TDS Advance Regular Penalty 1 Penalty 2 Interest Refunds Other TaxAssessmentRecoveriesReceiptsTDS 1.0000Advance tax 0.9545 1.0000Regular assessment 0.8884 0.9510 1.0000Penalty 1 0.1759 0.2716 0.1899 1.0000Penalty 2 0.7892 0.6638 0.5753 0.1454 1.000Interest recoveries 0.7837 0.8101 0.6510 0.6579 0.6037 1.0000Refunds 0.12950.30140.3590-0.1116-0.02330.03981.0000Other receipts -0.0629 0.1547 0.2737 -0.1250 -0.2598 -0.1545 0.6578 1.0000Table 5: Matrix (R) of Correlations between Various Components of Corporate TaxComponents of CT TDS Advance Regular Penalty 1 Penalty 2 Interest Refunds Other TaxAssessmentRecoveriesReceiptsTDS 1.0000Advancetax0.83521.0000 Regularassessment0.86820.97741.0000 Penalty1 -0.0609-0.0487-0.07271.0000 Penalty2 0.30110.61650.59390.06311.0000 Interest recoveries 0.2220 0.5480 0.5318 0.1393 0.3635 1.0000 Refunds 0.99830.84200.8666-0.04680.31200.21761.0000 Other receipts -0.1165 -0.0646 -0.0707 -0.3301 -0.1426 -0.2081 -0.1237 1.00001.3 Tax AuditIt is widely recognised that taxpayers’ perception of the probabi-lity of being audited strongly determines their degree of compli-ance. Thus, the importance that a tax administration assigns to the audit function greatly affects the ability of the organisation to enforce compliance. Even if a tax administration is very effective in registering taxpayers and detecting stop filers or delinquent taxpayers, the administration’s overall effectiveness will be low if auditing is not effective in discouraging evasion.In India, the taxpayer provides information to the tax admin-istration through returns and accompanying documents. These returns contain valuable information on the taxpayer and his activities. All this information is potentially used to help gauge the taxes due from taxpayers. Besides is, information is also col-lected through various information returns, which are collected from the third parties on various in-vestments or expenditures. Though a wide variety of sources of information can be imagined for col-lecting such information, the challenge of match-ing this third party information and collating it in a useful form is certainly a task. If we see the collection of personal income tax – pre-assessment and post-assessment, as percent-age of total collection, we find that there has not been any significant change in the tax collection – pre-assessment or post-assessment; in fact it has remained stagnant. This shows that despite the emphasis of the tax administration on improving the collection of information, the effectiveness of the use of information has not seen any significant improvement. Maybe the audit programmes, which are reported to be auditing 2-3 per cent of the tax returns are not able to control the underreporting of taxes! A comparison with some of the Organisation for Economic Cooperation and Development (OECD) tax administrations shows that the Indian tax administration is collecting significantly higher post-assessment taxes as percentage of total collec-tions. But there is no reason for complacency on this score as theOECD has better socio-economic conditions, social security systems, and better governance systems, which result in higher volun-tary tax compliance. A good indicator of the emphasis on the audit function is the number of employees engaged in audit work in any tax administration. InOECD countries, audit, investigation and other verification functions are, on an average, carried out by more than 25 per cent of the employees. Australian tax administration has 33.8 per cent employees in audit, investi-gation and other verification functions; Belgium 50 per cent, the US 18 per cent, Japan 68.4 per cent, Turkey 10.7 per cent and UK 13.9 per cent [OECD 2006]. In non-OECD countries like Argentina, the ratio of employees employed in audit and other verification functions is reported to be 34.4 per cent, Chile 60.2 per cent, such percentage deployment in India is not known. But an estimate of the deployment in India, taking into account the fact that each tax officer handles 150 cases every year on an average for audit, with a complement of four staff members on an average, shows that each employee handles the audit work of 37.5 cases. If we see the number of assessments per employee in other countries – developed and developing, we find that there is a definite pattern for deployment of employees for tax audit work. In Australia it is 4.58, US 1.16, Canada 4.04, South Africa 29.23, Turkey 11.28, Argentina 32.28, Chile 90.18 [OECD 2006]. Thus, developing countries, typically, have a large number of cases be-ing handled by each employee. Developed countries’ employees, on the other hand, handle a lesser number of cases, and so are able to devote a considerably longer period of time to create deterrence through tVe tax audits. An overview of the tax audit programme of developing coun-tries shows that these countries typically experience some im-provement in compliance and collection in the short-term but they tend to reach plateau within a few years after the first drastic changes are introduced and do not show any significant advances subsequently. This means that the tax administration needs to focus on its audit efforts by improving its information collec-tion, collation, and dissemination in a concerted manner. But the dilemma of whether the tax administration should engage its employees as tax enforcers or tax facilitators continues to affect Table 6: Arithmetic Mean and Standard Deviations of Observations on Variables TDS Advance Regular Penalty 1 Penalty 2 Interest Refunds Other TaxAssessmentRecoveriesReceiptsIT Mean⎯x 9999172743944471943929855653398761.7684776.14.6E+07243487Standard deviation σx 97237562 26096827 6482895 140906718993.4699472.7 4.8E+07 472321CT Mean⎯x 51657666 1.44E+08 37865022 59162.6 120306 3837706 8.2E+07 166036Standard deviationσx 756863431.35E+0835989010 93511.5 1625006500979 1.36E+08 253484Table 7: Eigenvalues (λi) for Income Tax and Corporate Tax (λ1) (λ2) (λ3) (λ4) (λ5) (λ6) (λ7) (λ8)IT 4.25731.90681.04860.38540.26380.11860.01310.0064CT 4.21981.44590.98360.65520.62410.05030.02030.0007
SPECIAL ARTICLEEconomic & Political Weekly December 15, 2007107such efforts. In fact, in many countries, it has been seen that the auditing has decreased in importance over a period of time rela-tive to other tax administration functions, as shown by the reduc-tion in the number of staff assigned to auditing as well as by the decrease in the percentage of taxpayers who are audited. 2 Voluntary Compliance and Enforcement MeasuresGiven the above perspective, it would be in order to examine the effectiveness of tax administration and attempt to construct an index to estimate the contribution of voluntary compliance and the enforcement measure. 2.1 TaxEnforcementIn common parlance, involuntary payment of taxes is linked to tax enforcement. But enforcement acts through two channels; directly, as involuntary collections are enforced by tax administration, and indirectly, as voluntary compliant tax pay-ments, induced by fear of enforcement actions. Efficient enforce-ment should have minimum actions, which can lead to a higher share of voluntary compliance relative to potential or theoretical maximum tax collections. This would also mean that voluntary compliant taxes should have a high share in the total tax collec-tions. A less efficient system would be one where a high share of collections requires strong enforcement actions. It also needs to be mentioned here that the efficiency of tax enforcement actions is not a stand-alone parameter; rather it also depends on the syn-ergistic relationships with other institutions in the economy, such as the responsiveness of the legal structure, trust in rule of law, and other social institutions. The term “tax enforcement” implies tax collection as per the statute of the tax laws. Taxes are to be paid according to the rules and provisions of the law, which are administered by the tax administration. Penalties are imposed for any lapses (either late payment or detection of undisclosed income) on the part of taxpayers. Various components of tax collection include (i)taxes deducted at source(TDS); (ii) advance tax payments; (iii) taxes paid on regular assessments; (iv) penalty 1 for detection of un-disclosed income, under Section 271(1)(c) of the Income Tax Act 1961; (v) penalty 2 – other than those under (iv); (vi) interest recoveries either for less payment or late payment of taxes; and (vii) other receipts, in the nature of residuary receipts.Any excess payment of taxes results in refund of the taxes. All tax payments are mandatory. But for convenience, one may classify them as, “voluntary” and “involuntary” payments. TDS and advance tax payments can be largely regarded as “vol-untary”, as they are paid by taxpayers before they submit any return of income.10 “Involuntary” payments are those arising out of regular assessment (such as, penalties 1 and 2, interest recov-eries, refunds and other receipts, including taxes paid on regular assessments).2.2 Tax Enforcement IndexIn this section, we propose to construct a tax enforcement index (ENF) for corporate tax (CT) and income tax (IT) as a weighted average of various tax components, based on the time series data (1985-86 to 2003-04) on various tax components available from published sources, such asThe Statistical Abstract of India. It should be noted that the tax components (i) to (vii) are not mutually uncorrelated. Pair-wise correlations between them are given in Tables 4 and 5 (p 106). We observe that corr (TDS, advance taxes) is of the order of 0.9545 for IT and it is 0.8352 for CT. The correlation betweenTDS and regular assess-ment is of the order of 0.8884 for IT and it is 0.8682 forCT; and so on. It is, therefore, not appro-priate to pick one of the components (say TDS or regular assessment, etc) and analyse the effect of changes in them on the enforcement or perform-ance of tax collection. There is need to compute a “composite index of enforcement” by combining various tax components in a suitable way (assign-ing appropriate weights to different components) and relate it to the tax productivity of the economy. While constructing the ENF as a weighted average of various tax components, it is crucial to determine weights to be assigned to each of these components. We propose a method of deter-mining the weights that take into account the variation in tax components over the entire period of observations, viz, 1985-86 to 2003-04. We regardENF as a latent variable, which cannot be measured in a straight for-ward manner but is sup-posed to be linearly deter-mined by various tax com-ponents. Supposing that we have an adequate set of tax components (deter-minants ofENF), we can assume that the total varia-tion inENF over years is accounted for by the varia-tion in various tax compo-nents and error variance is negligible. We exploit the total variation in all tax Table 8: Eigenvectors for Income Tax and Corporate Tax (α1) (α2) (α3) (α4) (α5) (α6) (α7) (α8)IT 0.4651 0.0309 -0.2360 -0.1226 -0.1355 -0.0785 0.6819 0.4717 0.4728 -0.1054-0.0423-0.1834-0.1622-0.07330.1612-0.8199 0.4399 -0.2046-0.0759-0.3367-0.10610.5820-0.49180.2315 0.1882 0.26670.8069 0.09190.20660.36090.2466-0.0126 0.3719 0.1925-0.3611 0.46050.67910.0479-0.1241-0.0577 0.4250 0.19140.30380.0732-0.1910 -0.6504-0.43110.1996 0.1100-0.61370.11750.7050 -0.29680.09390.04590.0379 0.0156 -0.6516 0.2217-0.33920.5618-0.29220.05510.0831CT -0.4371 -0.1764 -0.3755 -0.0361 0.0469 -0.3885 -0.0312 0.6939 -0.4758 -0.03780.1111 -0.06120.0217 0.6537 0.55640.1371-0.4794 -0.06040.0731 -0.0329 0.0332 0.3342-0.7940-0.1303 0.0073 0.6390-0.2676-0.7189 0.01900.0438-0.02980.0067 -0.2955 0.2048 0.4791-0.0393-0.7374 -0.3059 0.04830.0039 -0.2582 0.3579 0.5021 0.1239 0.6581 -0.3165 0.0661-0.0122 -0.4383 -0.1668-0.3785-0.04630.0283 -0.31650.2263-0.6946 0.0817-0.5980 0.3806-0.67670.1351-0.1196 0.0153-0.0053Table 9: Proportion of Variation Accounted for by Successive Principal ComponentsVariance of Pi Proportion Cumulative of Variance Proportion of Accounted (%) Variance Accounted(%)IT4.2573 53.2163 –1.9068 23.8350 77.05131.0486 13.1075 90.15880.3854 4.8175 94.97630.2638 3.2975 98.27380.1186 1.4825 99.75630.0131 0.1638 99.92000.0064 0.0800 100CT4.2198 52.7482 –1.4459 18.0740 70.82210.9836 12.2952 83.11730.6552 8.1901 91.30740.6241 7.8013 99.10870.0503 0.6288 99.73750.0203 0.2538 99.99120.0007 0.0088 100

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