India Government Sees Growth Imperiled With Rising Greek-Like Tax Evasion

By Tushar Dhara and Cherian Thomas - Jul 18, 2011

As Rama Murthy completes the sale of his three-bedroom apartment in the southern Indian city of Hyderabad, he accepts from the buyer a bag full of rupees -- a part of the purchase price the tax man will never see.

“Almost 40 percent of the sale price I got in hard cash,” said Murthy, 39, who works at a software maker. “It’s illegal, but it’s rampant in India to avoid paying tax.”

India loses 14 trillion rupees ($314 billion) from tax evasion annually, depriving it of funds for investment in roads, ports and power, said Arun Kumar, author of “The Black Economy in India.” General government tax revenue totals an estimated 18 percent of gross domestic product, the lowest among the four BRIC nations, and down from an average 19 percent the past five years, International Monetary Fund data show.

With so little revenue, the government must borrow more to fund a planned $1 trillion five-year infrastructure program needed to help secure Prime Minister Manmohan Singh’s target of 10 percent sustained economic growth. Singh is pushing to pass legislation by April 2012 that would pare exemptions and lower personal and company levies to improve compliance, in what would be the biggest income-tax overhaul in half a century.

“In the last 35 years we have been losing 5 percentage points of growth every year,” said Kumar, who teaches economics at Jawaharlal Nehru University in New Delhi. “Instead of 7.5 percent now we could have grown at 12.5 percent. What China and Southeast Asia achieved, we could have done.”
Yields Rising

India’s 10-year government bond yields climbed 27 basis points yesterday from April 1, the start of the fiscal year, to 8.26 percent, partly on concern the government may borrow more than its 4.17 trillion rupee target for 2011-2012. Yields on similar-maturity Chinese debt rose 2 basis points, Brazil’s fell 40 basis points and Russia’s ticked up 1 basis point. Treasury yields tumbled 56 basis points, or 0.56 percentage point.

“If the government does end up making a substantial amount in revenue as a result of the tax overhaul, their deficit requirements should come down and the interest burden will also come down,” said Killol Pandya, Mumbai-based head of fixed income investments at Daiwa Asset Management (India) Pvt. The prospect “enthuses me as a bond investor,” he said.
‘License Raj’

India’s post-independence tax and regulatory code created incentives to keep transactions outside the tax system. Singh began attacking that structure as finance minister in 1991, accelerating tax cuts and reducing the bureaucracy. The top individual income tax rate is now 30 percent, from 97.5 percent in 1971. The country’s debt still exceeds that of other BRIC nations, which group India with China, Russia and Brazil, as a share of the economy, IMF data show.

“For every little thing, companies needed license from the government,” said D. H. Pai Panandiker, president of RPG Foundation, a New Delhi-based research group. The so-called “license raj” encouraged the creation of the underground economy, he said.

Even today, “no permission is available without the payment of money, so the cost of doing business is very high,” said Sharad Kumar Saraf, the managing director of Mumbai-based Technocraft Industries, which makes steel pipes and fittings for export.

India’s government revenue as a share of GDP compares with 36 percent in Brazil, 37 percent in Russia and 21 percent in China, the IMF says. Its debt ratio is 68 percent, against China’s 17 percent, Russia’s 8.5 percent and Brazil’s 66 percent.
Greek Example

In a country where the per capita income is 50,000 rupees and the income tax exemption limit is 180,000 rupees, only 3 percent of India’s 1.2 billion population pays tax, according to the finance ministry. Endemic tax evasion makes it tougher to stem any crisis in investor confidence, as Greece discovered last year. The IMF made addressing tax compliance a key part of its loan program for the European nation.

Singh’s government, which has been rocked over the past year by its own corruption challenges, including a scandal over the award of telecommunication licenses, in March appointed three research institutes to estimate the size of the so-called black-market economy. They are scheduled to release their findings and policy recommendations by August 2012.

Singh a year ago introduced the so-called Direct Tax Code legislation to overhaul levies on companies and households. It would cut the corporate rate to 30 percent from the current 33 percent and phase out tax “holiday” periods that give businesses incentives to alter the timing of their transactions.
Incentive to Cheat

“When you give these kinds of tax incentives there is always the possibility for misuse in the form of money laundering and shifting of profits,” said Sunil Gupta, a finance ministry official who helped write the legislation. He said he hoped it would be enacted by the start of the 2012-2013 tax year next April. Gupta estimated India loses as much as 800 billion rupees a year because of corporate tax incentives.

The bill aims to bring more individuals into the net by minimizing exemptions, such as for some real-estate transactions and investments in infrastructure bonds and equity mutual funds. It would boost by 200,000 rupees a year the sum an individual has taxed at the lower 20 percent rate.

“Every certified accountant, lawyer and doctor and small services provider isn’t interested in being part of the system,” said Kavita Rao, an economist in New Delhi at the National Institute of Public Finance and Policy who will lead one of the three black-market economy studies. “It penalizes the guys who pay taxes.”
Single Tax

A separate effort to overhaul indirect taxes may prove more challenging as it requires an amendment to the constitution. Singh plans legislation to introduce a nationwide goods and services tax, or GST, that would replace most indirect taxes.

The bill may also abolish a state-by-state entry tax that truckers must pay when they transport items across the country, said Vivek Johri, an Indian Revenue Service official at the finance ministry who is helping write the proposed legislation.

Should all the different indirect taxes be replaced by a single levy, it will be easier to conduct audits of companies, Johri said. “Right now there are too many government tax agencies who are not talking to each other. That will change.”

A third effort is to rewrite a tax treaty with Mauritius, an Indian Ocean island chain and suspected destination of a share of flows of unreported income out of India. Finance Minister Pranab Mukherjee said June 21 the two have resumed talks on the matter. Under the current arrangement, capital gains on Indian shares held by a Mauritian company aren’t subject to Indian tax.
Hamstrung in Parliament

One challenge underlying all of the initiatives is a political paralysis in parliament that’s hamstrung Singh since corruption charges erupted over irregularities in the 2008 sale of licenses to run mobile-phone services. One minister was forced to resign over the scandal and is in jail along with a federal lawmaker and company executives as their trial continues.

“The government must start the reform process once again,” Adi Godrej, chairman of Godrej Consumer Products Ltd. (GCPL), said in an interview with Bloomberg UTV on July 8. “Because of the corruption scandals the government went into hibernation. The most important legislation that could really kickstart the economy quickly to 10 percent growth is the introduction of the GST.” India’s GDP expanded 7.8 percent in the first quarter from a year before.

Another reason for lawmakers’ reluctance to embrace the government’s legislation is that a portion of India’s unreported cash is plowed into election campaigns, analysts said.

“The mother of all corruption in India is election corruption,” said N. Bhaskara Rao, chairman of New Delhi-based Center for Media Studies. “The biggest outlet for black money is election spending and political parties will only be curtailing their spending power by backing proposals to curb black money.” He estimated that parties spend $22 billion a year on elections to state and parliamentary seats.

Unreported money sometimes goes back into the economy: Murthy, who sold his apartment for 2.2 million rupees, said he used part of his bag of cash to buy a refrigerator and an air conditioner.

To contact the reporters on this story: Tushar Dhara in New Delhi at tdhara1@bloomberg.net; Cherian Thomas in Bangalore at cthomas1@bloomberg.net

To contact the editor responsible for this story: Stephanie Phang at sphang@bloomberg.net
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