Economics of taxation: incidence, revenue response, tax-to-GDP and tax expenditure

Detail

1. Impact, incidence and shifting

Three basic words

• Impact: the legal liability. It falls on the person who hands the tax to the government.

• Example: a shopkeeper collects GST and deposits it, so the impact is on the shopkeeper.

• Tax incidence: the final burden. It falls on the person whose real income actually goes down.

• Example: if the shopkeeper raises the price by the full tax, the incidence is on the buyer.

• Shifting: the process that moves the burden from the person with the impact to the person who bears the incidence.

Two directions of shifting

• Forward shifting: the tax is passed on to buyers through higher prices.

• Common for indirect taxes such as GST and excise.

• Backward shifting: the tax is passed on to suppliers or workers through lower input prices or lower wages.

• Example: a firm facing a tax pays farmers less for raw material, or gives workers smaller pay rises.

Direct vs indirect tax, seen through incidence

• Direct tax: impact and incidence fall on the same person, for example income tax. It is hard to shift.
• Indirect tax: impact and incidence fall on different people, for example GST. It is easy to shift.
• Why this matters:
• Indirect taxes take the same rupee amount from rich and poor buyers.
• So they take a bigger share of a poor person's income. This makes them regressive (they take a larger share of income from the poor).

Rule: the burden falls on the less elastic side of the market

• Elasticity means how strongly buyers or sellers react when the price changes.

• Inelastic means they barely react.

• Buyers' share of the tax = Es ÷ (Es + Ed)

• Es = elasticity of supply.

• Ed = elasticity of demand, taken as a positive number.

• Sellers' share of the tax = Ed ÷ (Es + Ed)

• Worked example: a tax of ₹10 per packet of cigarettes, with Es = 2 and Ed = 0.5.
• Buyers bear 2 ÷ 2.5 = 80%, so ₹8.

• Sellers bear 0.5 ÷ 2.5 = 20%, so ₹2.

• Cases

• Cigarettes, petrol: demand is inelastic because people are addicted or have no substitute. So buyers bear most of the tax.

• Goods with close substitutes: buyers can switch easily, so sellers bear more of the tax.

• See the Demand Elasticity note.

Link to national income (Class 12, National Income Accounting)

• Product taxes (such as GST and excise) are charged per unit of a product.
• Production taxes (such as land revenue and stamp duty) are paid just for producing, whatever the amount produced.
• GDP at market prices = GVA at basic prices + product taxes − product subsidies.
• So indirect taxes widen the gap between what buyers pay and what producers receive.
• This gap is the "wedge" where incidence is shared between buyers and producers.

2. Laffer curve: can lower rates raise revenue?

Definition

• The Laffer curve (Arthur Laffer, 1974) plots tax revenue (vertical axis) against the tax rate (horizontal axis).
• It is linked to supply-side economics: the view that lower taxes lead people to work, save and invest more, so output grows.

Shape

• At a 0% rate, revenue is zero.
• At 100%, revenue is also zero, because nobody works or reports income.
• In between, revenue first rises and then falls. The peak is the optimum rate (t*).
• Past t*, a higher rate brings in less revenue because people:
• work less;
• avoid tax, legally, for example by using loopholes;
• evade tax, illegally, for example by hiding income.

Worked example (made-up numbers)

• At a 30% rate, the declared tax base is ₹100 crore, so revenue = ₹30 crore.
• At a 50% rate, the declared base shrinks to ₹50 crore because more income is hidden, so revenue = ₹25 crore.
• Here, cutting the rate from 50% to 30% raises revenue. This shows the economy was on the "wrong side" of t*.

Indian tests

• After 1991: personal and corporate tax rates were cut.
• Class 11, Liberalisation, Privatisation and Globalisation: An Appraisal: "moderate rates of income tax encourage savings and voluntary disclosure of income".
• The same chapter warns: "the tax reductions in the reform period … have not resulted in increase in tax revenue".

• Lesson: lower rates help only when the base widens and compliance improves.

• 2019 corporate-rate cut: the latest test (see Section 3).

• 2025-26 personal tax relief: under the new regime, no income tax is payable on total income up to ₹12 lakh (about ₹1 lakh a month), except special-rate income such as capital gains [8].
• This is a bet on lower rates plus simpler compliance.

Limits of the Laffer idea

• Nobody knows exactly where t* lies. It differs by country and by type of tax.
• Rate cuts made while the economy is below t* simply lose revenue.

3. Buoyancy vs elasticity: how revenue responds to growth

	Tax buoyancy	Tax elasticity
Formula	% change in tax revenue ÷ % change in GDP	Same ratio, with tax rates and base held constant
Includes	Discretionary changes (new rates, new taxes, base widening, better enforcement)	Only the automatic response to growth
Reading	Above 1: revenue grows faster than GDP (desirable)	Shows how well built-in the tax system is

Worked example

• Revenue rises 12% and GDP rises 10%, so buoyancy = 12 ÷ 10 = 1.2.
• Suppose 3 of those 12 percentage points came from a new rate increase.
• The automatic growth is then 9%.

• So elasticity ≈ 9 ÷ 10 = 0.9.

• Reading: the system looks buoyant only because of policy action. Its built-in response is below 1.

Indian data

• Tax buoyancy 2021-22: 1.9 overall. Direct taxes 2.8, indirect taxes 1.1 [4].

• Direct taxes respond more to growth because of progressive slabs (tax rates rise as income rises), and because rising incomes move people into higher slabs.

• Tax revenue 2021-22 exceeded the Union Budget estimates by about ₹5 lakh crore [7]. This was a post-COVID rebound in buoyancy.

• Gross Tax Revenue (GTR), BE 2026-27: ₹44.04 lakh crore, 8.0% growth over RE 2025-26 [2].
• BE (Budget Estimate): the figure planned in the Budget.

• RE (Revised Estimate): the updated figure for the running year.

• Real GDP growth, 2025-26: estimated at 7.4% [3].

• When nominal GDP (GDP at current prices) grows faster than 8%, buoyancy falls below 1. This is a warning sign for fiscal space.

4. Tax-to-GDP ratio and composition

Definition

• Tax-to-GDP ratio = (Total tax revenue ÷ Nominal GDP) × 100
• It shows how much of the economy's income the state can raise to spend on roads, schools, defence and welfare.

India: levels

• Centre's gross tax: 11.2% of GDP (BE 2026-27) [2] (NCERT scaffold: about 11.5-12%).

• Worked check: ₹44.04 lakh crore ÷ 0.112 ≈ ₹393 lakh crore nominal GDP (derived figure).

• Centre's net tax (after the states' share is passed on): 7.9% of GDP (Class 12, Government Budget and the Economy, Table 5.1, 2024-25 provisional actuals).

• Gross vs net: under Article 270, a part of central taxes is shared with the states, based on the Finance Commission's award.

• General government (Centre + states): about 17-18% of GDP.

International comparison

• OECD average tax-to-GDP: 34.1% (2024). This is the highest ever recorded, up 0.3 percentage points from 33.9% (2023) [6].
• OECD range (2024): Mexico 18.3% (lowest) to Denmark 45.2% (highest) [6].
• So India's general-government ratio is close to Mexico's and about half the OECD average.
• Reasons for India's low ratio:
• a large informal sector (small, unregistered businesses and workers that pay little tax);
• a narrow income-tax base, with most farm income exempt;
• many exemptions (see Section 5).

Composition

• Direct taxes, BE 2026-27: ₹26.97 lakh crore = 61.2% of GTR [2].
• Indirect taxes, BE 2026-27: ₹17.07 lakh crore [2].
• Direct taxes are now over half of the Centre's gross tax. Personal income tax has overtaken corporation tax.
• Why this is good:
• Direct taxes are progressive (people with higher incomes pay a larger share of their income).
• More reliance on them makes the system fairer.

5. Tax expenditure and tax incentives

Definition

• Tax expenditure is revenue the government gives up through exemptions, deductions, rebates and concessions.
• It works like a hidden subsidy:
• No money is spent from the budget.
• But the effect equals giving that money as a grant.

• Unlike a grant, it is not voted each year.

• Worked example

• A taxpayer in the 30% slab claims a ₹1.5 lakh deduction.
• Tax forgone = ₹1.5 lakh × 30% = ₹45,000, ignoring cess.
• Multiply this across crores of taxpayers to get the tax expenditure.

How it is reported

• It has been reported every year since 2006-07.
• It was first published as a separate "Statement of Revenue Foregone" [5].
• From Budget 2016-17 onwards, it has been an annex to the Receipt Budget, now called the "Statement of Revenue Impact of Tax Incentives" [5].

Tax incentives narrow the base

• Examples: incentives for industries in backward areas, and for foreign investors.
• Class 11, Liberalisation, Privatisation and Globalisation: An Appraisal: they "further reduced the scope for raising tax revenues".
• Costs of incentives
• Revenue loss.
• Distortion: firms choose a location or activity for the tax benefit, not for efficiency.
• Lawsuits and complicated rules.

Tax holiday

• A tax holiday is a temporary full or partial exemption for new firms or investments.
• SEZ units: income-tax holiday under Sec. 10AA, only for units that started operations by 31 March 2020 (the sunset date, after which new units do not qualify).
• Budget 2026-27 (verify current):
• extended the IFSC-unit holiday from 10 to 20 years;
• gave a holiday to 2047 for cloud services from Indian data centres.

The new-regime logic

• Offer lower rates in exchange for fewer exemptions.
• Result: tax expenditure shrinks, compliance gets simpler, and there are fewer disputes.
• This also moves the system towards the efficient side of the Laffer curve, through a wider base and moderate rates.

Timeline hook

• 1860: income tax introduced.
• 1991 onwards: rates cut.
• 2006-07: tax expenditure statement begins.
• 2017: GST.
• 2019: corporate-rate cut.
• 2025-26: ₹12 lakh zero-tax limit [8].
• Global minimum tax: the same logic at world level. It limits a "race to the bottom" through incentives.

Prelims Hooks

• Impact = legal liability (who deposits the tax). Incidence = final burden (whose real income falls).
• The tax burden falls on the less elastic side. Buyers' share = Es ÷ (Es + Ed).
• Tax buoyancy includes discretionary changes. Tax elasticity holds rates and base constant. Buoyancy > 1 means revenue grows faster than GDP.
• India's tax buoyancy 1.9 in 2021-22 (direct 2.8, indirect 1.1) [4].
• Laffer curve: Arthur Laffer, 1974. Revenue is zero at both 0% and 100% tax rates.
• Centre's GTR-to-GDP 11.2% (BE 2026-27). Direct taxes 61.2% of GTR [2].
• OECD average tax-to-GDP 34.1% (2024). Mexico 18.3% (lowest), Denmark 45.2% (highest) [6].
• The "Statement of Revenue Impact of Tax Incentives" (earlier "Statement of Revenue Foregone") is an annex to the Receipt Budget, not the Annual Financial Statement [5].
• Trap: the Sec. 10AA SEZ tax holiday applies only to units that started operations by 31 March 2020.
• GDP at market prices = GVA at basic prices + product taxes − product subsidies.

Mains Points

• Low tax-to-GDP limits the state (GS-III)
• India's general-government ratio is about 17-18%, against the OECD average of 34.1% (2024) [6].
• This leaves little money for health, education and capital spending.

• Remedy: widen the base (formalisation, GST, data analytics), not raise rates.

• Rate cuts vs revenue: the Laffer debate

• After 1991, lower rates improved disclosure, but NCERT notes that revenue did not rise on its own.

• The 2019 corporate cut and the 2025-26 ₹12 lakh limit [8] work only if exemptions are also removed.

• Tax expenditure as a hidden subsidy

• It escapes yearly scrutiny by Parliament and mostly helps richer taxpayers and firms.
• Phasing out exemptions (new regime, sunset clauses) improves fairness and transparency.

• Trade-off: targeted holidays (IFSC, data centres) are meant to attract investment.

• Incidence and equity

• Indirect taxes are shifted forward onto consumers and hit the poor harder.
• So the rising share of direct taxes (61.2% of GTR, BE 2026-27) [2] makes the tax system more progressive (the better-off pay a larger share of their income).
• GST rates must also consider how elastic demand is for essential goods.