The air is filled with the possibility of reforms in the administration of personal income tax. The architect of the most famous tax reform in India, Mr. P C Chidambaram, is again the Finance Minister. What will he do, what can he do, to bring extra buoyancy into the collection of personal income taxes (PIT). He faces several roadblocks, not the least of which is the fact that a large part of the babu economics fraternity is unconvinced of the efficacy of the first set of tax reforms. Which is a tragedy, but not surprising, given the amount of morality and ideology associated with the political economy of PIT.

It is worthwhile to review what happened in the dream budget reform of 1997/98. In the hope that reducing tax rates would increase compliance (i.e. filing of tax returns by those who should) , Mr. Chidambaram reduced tax slabs to only three and tax rates by 10 percentage points in each tax slab i.e. 40 became 30 percent, 30 became 20 percent. If the Indian taxpayer did not respond to the incentive to comply, the government faced a large reduction in tax revenue of approximately 25 percent to about Rs. 14,000 crores compared to the Rs. 18,231 crores tax receipts in 1996.

In reality, PIT collections in 1997 were Rs. 17,100 crores excluding the Rs. 10,000 crores generated by the VDIS scheme. In effect, therefore, in the year of enactment the tax reform was near revenue neutral with old tax rates - and yielded considerably higher tax revenue than old compliance levels would have dictated. Mr. Laffer had the last laugh as Mr. Chidambaram proved both the Left and the moral brigade wrong - cutting tax rates actually increased the tax base, and therefore helped in extra revenue generation. It can be argued, at least theoretically, that future tax cuts may not increase tax compliance from their present levels. What is amazing, however, is that large sections of the policy wonk intelligentsia actually believes that the 1997/1998 tax reforms did not increase the tax compliance from the 1996/97 levels.

By way of explanations, these experts argue that increased compliance came about via either increased TDS compliance, or via the one-in-six scheme, or from the fact that with economic growth, there is more income to be taxed. All of these arguments have merit and can possibly explain some of the increase in tax revenues from the situation that prevailed in 1996/97. But none of these arguments can explain the large increase in compliance that took place in the immediate year 1997/98 itself. Perhaps, the experts can argue, compliance increased in 1997/98 because of the VDIS scheme, but then one is left in the uncomfortable position of endorsing tax amnesty schemes - which the moral brigade does not favor, because it is not interested in tax revenue as much as in the "principle" of taxation of the rich.

Contrary to the arguments of the experts, publicly available data suggests that the 1997/98 tax reform was a huge success both in generating extra compliance and extra revenue. (Note that if tax cuts are 10 percent then compliance has to increase by 10 percent to yield the same old revenue.) The 1997/98 tax cuts yielded extra revenue over the ensuing years. Consider the following for 1996/97 and 2000/01, the latter year chosen because of the million sample tax survey undertaken by the Kelkar task force. Number of tax returns increased from 0.9 in 1996/97 to 2.1 crores in 2000/01. Some of this increase is attributable to the fact that with growth, there are more eligible taxpayers. This growth induced increase in taxpayers is estimated to have increased from 39 crores to 48 crores taxpayers in the corresponding years i.e. an increase of only 23 percent compared to the more than a 100 percent increase in actual tax returns (0.9 to 2.1).

Perhaps the number of taxpayers increased mostly at the low end, so revenue generation was not helped so much. Wrong again. In 1996/97, actual tax collections were about 18 percent of the possible; in 2000/01, this ratio had risen to 27 percent. Thus it is not the case that increase in compliance was concentrated overwhelmingly at the poorer end of the taxpayers. Finally, consider the implication for revenue induced increase of the tax cut. Today, there is an absolute revenue gain of something of the order of 20 to 30 percent. In other words, if in 2004/05, PIT collections are in the Rs. 48,000 to Rs. 50,000 crores range, then this will be about Rs. 12,000 crores more than that which would have been generated with the old, higher tax rates and lower compliance (Rs. 36,000 crores). Special thanks, therefore, to the compliance increasing and revenue enhancing gains from lower tax rates instituted by Mr. Chidambaram in 1997/98.

But a lot more can be done today as revenue not collected due to lack of compliance is about three times that which is actually collected i.e. there is about 3 percent of GDP, or Rs. 100,000 crores of tax not collected from non-agricultural tax payers in 2004/05. Surely a major thrust of tax policy should be to tap this resource base.

For reasons of destiny, and regardless of what policymakers do or do not do, whether in this budget or the next or the next, whether by the NDA or the UPA or any combination thereof, India's economic performance is likely to exceed that achieved in the past. A safe bet, argued by a few earlier but now rapidly converging to conventional wisdom, is that India, without additional economic reforms, is likely to grow at a 6.5 to 7.5 percent pace. With reforms, and here the debate gathers pace, India can do much better i.e. grow at 8 percent plus and beyond. An important element of these future (futuristic?) reforms is what India does with regard to its national debt and its enlarged fiscal deficits. Such government (central plus state) excesses are currently in the range of 10 percent plus; the future direction of interest rates and efficient growth involves a reduction of such deficits to somewhere around 4 to 6 percent of GDP.

How is the consolidated (state and center) fiscal deficit to be reduced by 4 percentage points? There is one strand of argument that states that we are taxing too little of GDP and our social spending to GDP ratio is also below what it "should" be. Hence, the proper course of action is to increase the tax/GDP ratio to its norm, and use such proceeds to increase expenditure to our inflated norms. Thus nothing really happens to fiscal reduction i.e. it is the case that such advocates of social reform explicitly believe that "Fiscal deficit bhad me jaye".

There are others (I being amongst them) who believe that India does not tax too little, and already spends too much i.e. the cause of the fiscal deficit being high is not in our low taxing but in our high spending. Now, blessed with the reality of India's higher growth rate, we should not increase the amount of total spending, but instead increase the efficiency of tax collection (flat tax, anyone?) and use these extra tax proceeds to permanently reduce the fiscal deficit. What Mr. Chidambaram Mach II delivers on Feb. 28 will be the best indicator of the true nature of the UPA government i.e. is it more interested in being a moral cat rather than a pragmatic one whose major goal is to catch mice.