Although direct taxes formed less than 3 per cent of GDP on the eve of reform (about 20 per cent of total tax revenues), they exerted a profound influence on economic decisions, the generation and availability of savings for the private sector and the pattern of investment. The impact of the direct taxes on the economy was disproportionate to their relatively small share in total tax revenues.

The system of direct taxes was unnecessarily complicated, deficient in terms of horizontal equity and destructive of incentives because of high combined marginal rates of personal income and wealth taxation as well as high rates of taxation of corporate profits. Erosion of horizontal equity arose through unjustified concessions, provision of tax shelters in the form of untaxed perquisites and weak enforcement which made it possible for a large section of the tax payable population to get away with no or little payment of tax. The top marginal rate of income tax including surcharge was 56 per cent and the top marginal rate of wealth tax was 2 per cent. Thus with a marginal rate of return of 10 per cent on wealth, the combined marginal rate of income and wealth taxes on capital income worked out to 76 per cent. As there was no automatic indexation of inflation and as the average rate of inflation was around 8 per cent during the 80s, the real rate of return after tax was negative if the nominal rate of return before tax was 10 per cent. This was so even if no wealth tax was payable.

The rate of corporate profit tax for widely held companies was 45 per cent whereas for closely held companies the rate was 50 per cent. On this there was a surcharge of 15 per cent (the rate of profits tax for foreign companies was 65 per cent). Such high rates of corporate profits tax combined with a tax on dividend as part of regular income in the hands of the shareholders led naturally to a low rate of return to equity holders, besides leaving very little in the hands of companies, which are the main engine of industrial growth, for investment.

Such high rates could continue only because of large-scale evasion and because of the provision of adequate tax shelters for those who advocated and introduced the high rates of tax. Members of Parliament and Central government Ministers receive relatively low salaries but then they are granted a sitting allowance which is exempt from tax. A proportion of government servants as well as Ministers and Members of Parliament were and are provided with living accommodation for which they are charged very nominal rates while the market rent for the accommodation would be several times higher. If the fortunate occupant of government accommodation paid 10 per cent of his salary as rent, no perquisite value is deemed to arise. Similarly, senior civil servants and top personnel in the organised private sector receive perquisites, which are not subject to tax fully; for example, use of telephones provided by the employer, leave travel concession, use of passenger cars given by the employer for private pur­poses on payment of relatively low charges. In a similar fashion very liberal rules for the valuation of house property for wealth tax purposes made possible for some groups of people to pay very little wealth tax. The tax law was unnecessarily complicated partly because of the provision of several concessions and deductions, but also because the Tax Department wanted to provide safeguards against every possible attempt at tax avoidance and tax evasion. The result was the generation of a plethora of disputes, growing litigation, with the Tribunals and High Courts coming to have such a large volume of pending cases that one could not hope to get a decision on an income tax case from the High Court within a period of 10 years. Most of the disputes related to minor points of interpretation involving insignificant amounts of money were taking up enormous time and effort, which was totally meaningless in view of the large-scale evasion of direct taxes.

We had built up a totally irrational structure of indirect taxes. The Constitu­tion provides for the imposition of a number of indirect taxes. But the major ones are customs and excise duties leviable by the Central government and the sales tax other than inter-State sales tax leviable by the State governments (the inter-State sales tax is levied under Central legislation). The irrationality in the indirect tax structure arose partly because of the nature of the Constitutional provisions but mainly because, in developing the indirect tax structure after independence, no attention was paid to the economic consequences of different ways of levying indirect taxes.

Prior to 1986, the indirect taxes levied by the Centre — customs, Union excise and Central sales tax — taken by themselves or the Central indirect taxes and the major indirect taxes levied by the States and the local authorities — taxes on intra-State sales, the passengers and goods tax, the electricity duty and the octroi^[1] taken together did not constitute an integrated and rational system. There were levies that have been developed independently with no coordination, and acted and reacted on one another with little government intervention. They were all cascading type taxes, except for the limited operation of a rule under the Central excise which provided credit for tax paid on inputs and the similarly limited concessional treatment granted to inputs in the sales tax laws in some States. The taxes were levied at widely different rates and the total impact on relative prices or on the pattern of expenditure of households could not be easily known; nor did the government bother about such matters although they swore by the commitment to progression and equity in the distribution of tax burden. To quote the Tax Reforms Committee (1991):

It was a truly irrational system from the economic as well as equity point of view; and the misallocation of resources and the loss of welfare caused by the high and desperate import duties and the multi-rated cascading type excise and sales taxes was palpable. While the unduly large number of rates resulted in classification disputes, the high rates spawned evasion abetted by corruption (p. 98).

In 1986 a system called MODVAT was introduced in the Central excise under which excise paid on many important inputs became eligible for credit against tax payable on output. This represented a major step in the reform of the Central indirect tax system. However, under the MODVAT system only tax paid on inputs that physically get incorporated in output or those that get consumed in the process of production qualified for set-off. Capital goods were not covered by MODVAT. Also three important sectors, namely, petroleum products, tobacco products and textile products were kept outside this system. After the changes introduced in 1986, there was hardly any progress towards a full-fledged value added tax.

While there had been some sincere attempt to reform the Central excise, there was no attempt to reform the import duty structure. In fact, in pursuit of the revenue objective, duty rates were considerably raised in the late 80s. At the beginning of the 90s, the Indian import duty structure

presented a bewildering picture of combination of ‘basic’ and ‘auxiliary’ duties with combined rates on different goods varying widely and often consisting of double application of ad valorem and specific duties. (Interim Report, p. 38)

The duty rates ranged from over 400 per cent ad valorem to 0 per cent. With the bulk of the imports falling in the range of 50 to 150 per cent, the average effective rate worked out to 85 per cent excluding exempted items (around 50 per cent if they are included). Furthermore, the statute gave only the maximum rates. The actual rates applied to different products or their varieties were fixed through numerous executive notifications. The notifications gave exemptions or concessional treatment to particular classes of users or sub-categories of goods, introducing further rate differentiation.

The special treatment given to the small scale sector under the excise taxation system represented and still represents another distortion. The concessional tax system extended to this sector has been a source of substantial tax evasion. The exemption of a substantial part of the industrial sector from excise taxation represents an obstacle to the introduction of a full-fledged value added tax.

As can be easily imagined, the application of many rates of excises led to numerous classification disputes. Much time, effort and money was expended by the department and the assessees in relation to disputes regarding classification. Of course, if the tax is limited to the manufacturing stage, there is always a temptation for the producers to under-estimate the values of the products. Apart from this, there have been problems arising from the difficulty in unambiguously defining the manufacturer’s price.

On the irrational and complicated structure of central indirect taxes represented by import and excise duties, was imposed the State sales taxes. The State sales taxes are levied on industrial as well as agricultural products; however, numerous exemptions are granted. the sales tax is imposed on prices inclusive of excise. Various types of sales taxes were experimented with by the different States, but most of them have shifted, in the main, to a first-stage, single-point tax, although in some States this is supplemented by a low rate turnover tax or an additional tax payable by the larger dealers.^[2]

The sales taxes in the different States are also levied at many rates and the rates of tax on particular commodities vary between States. As already noted, in general the sales taxes levied by the States are of the cascading type. To quote a recent report by the National Institute of Public Finance and Policy (1994), Reform of Domestic Trade Taxes in India

Neither the structures nor the procedures are, however, simple in any State. Also, with the shift in the point of levy to the first point, the problems in excise taxation associated with the definition of manufacturing, under valuation and commodity classification, are revisited when one looks at the sales tax system. In sheer complexity and irrationality, the sales tax systems, as they are structured and implemented at present, surpass the excise even at their worst (p. 12).

This is not all. In 1956 the Central government enacted the Central Sales Tax Act authorising the States to impose a tax on inter-State sales emanating from within their respective territories. The tax was imposed on the recommendation of the Taxation Enquiry Commission, 1953–54, which argued that the producing State (i.e., state of origin) should get a small part of the total sales tax burden that could be imposed on a commodity. That Commission recommended that the rate of the inter-State sales tax (CST) should be fixed by the Central government and suggested a 1 per cent rate of tax, presumably believing that such a low rate of tax would not be a serious barrier to inter-State trade nor lead to any significant cascading. In course of time, the rate of Central sales tax was raised by the Central government in stages to 4 per cent which taken together with the unremitted sales tax on inputs not only became an effective barrier to inter-State trade but also added significantly to the total cascading effect. Incidentally, the 4 per cent inter-State sales tax combined with the unremitted sales tax on inputs made possible substantial tax exportation by the industrially more advanced States. It is obvious that the rate of Central sales tax was raised with connivance of the Central planners in the mistaken belief that such increases would enable the States as a whole to raise more resources, whereas in fact the taxable capacity of the States to which there was net exportation of inter-State sales tax was reduced.