(IGP) GS Paper 1 - Economic & Social Development - "Taxation System In India: Concepts & Policies"

Integrated Guidance Programme of General Studies for IAS (Pre)

Subject - Economic and Social Development
Chapter - Taxation System In India: Concepts & Policies


Tax is a payment compulsorily collected from individuals or firms by government. A direct tax is levied on the income or profits of an individual or a company. The word ‘direct’ is used to denote the fact that the burden of tax falls on the individual or the company paying the tax and can not be passed on to anybody else. For example, income tax, corporate tax, wealth tax etc. An ‘indirect’ tax is levied on manufacturing and sale of goods or services. It is called ‘indirect’ because the real burden of such a tax is not borne by the individual or firm paying it but is passed on to the consumer. Excise duty, customs duty, sales tax etc.

Funds provided by taxation are used by governments to carry out the functions such as:

  • military defense

  • enforcement of law and order

  • redistribution of wealth

  • economic infrastructure — roads, ports etc

  • social welfare

  • social infrastructure like education, health etc

  • social security measures like pensions for the elderly, unemployment benefits

Taxation System in India

India has a well developed tax structure. Being a federal country, the authority to levy taxes is divided between the central government and the state governments. The central government levies direct taxes such as personal income tax and corporate tax, and indirect taxes like customs duties, excise duties and central sales tax (CST). CST is assigned to the States in which it is collected. (Art.269). The states have the constitutional power to levy sales tax apart from various other local taxes like entry tax, octroi, etc.

Service Tax

Service tax was first imposed in 1994. Today the rate is 12% and a 3% education cess is additionally imposed. More than 100 services are being taxed.

The service sector has emerged as an important area of economic activity. Reasons for taxing services

  • Its share in the country’s Gross Domestic Product (GDP) has increased from about 28% in 1951, to 55% (2011).

  • Taxing services is important to raise resources and increasing the tax-GDP ratio

  • service providers should share the tax burden with others-industry

Service Tax and Indian Constitution

  • The 88th amendment to the Constitution (2004) amended Article 270 (made it divisible) and inserted in the Union List (List I) entry No. 92C — ‘taxes on services’.

  • The amendment to the Constitution places services tax formally under the Union List, This will pave the way for the Centre to levy and collect the tax.

  • The amendment becomes redundant with the introduction of GST in 2011 where the services will be jointly taxed by Centre and States.


  • Goods and Services Tax is a multi-point sales tax with set off for tax paid on purchases of inputs. There is no cascading (tax on tax) effect as there is deduction or credit mechanism for taxes paid for the inputs. The tax is levied on the value added and on consumption only. Total burden of the tax is exclusively borne by the domestic consumer. Exports are not subject to GST.

  • The goods and service tax (GST) is proposed to be a comprehensive indirect tax levy on manufacture and sale of goods as well as services at a national level. Integration of goods and services taxation would give India a world class tax system and improve tax collections. It would end the long standing distortions of differential treatments of manufacturing and service-sector. The introduction of goods and services tax will lead to the abolition of taxes such as octroi, Central sales tax, State level sales tax, entry tax, etc and eliminate the cascading effects tax on tax.

Constitutional Amendment for GST

Constitution (One Hundred and Fifteenth Amendment), Bill, 2011 (OST Bill) was introduced in the Parliament in the budget session in March 2011, deals with GST. The Bill seeks to introduce Goods and Services Tax (GST) and the GST Council. As per the existing structure of indirect taxation, the Parliament has the power to make laws on the manufacture of goods and the provision of services (Union List) while the State Legislatures have the power to make laws on the sale and purchase of goods within their respective states (State List). The Parliament has retained the exclusivity to make laws pertaining to sale of goods in the course of inter-state trade or commerce.

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Seventh Schedule

The Union Government has the exclusive power to levy excise duty on the manufacture or production of the following:

  • Petroleum Crude

  • High Speed diesel
  • Petrol
  • Natural Gas
  • Aviation Turbine Fuel
  • Tobacco and Tobacco Products

The State Governments shall have the power to levy tax on the sale (other than in the course of inter-state trade or commerce) of petroleum crude, high speed diesel, petrol, natural gas, aviation turbine fuel and alcoholic liquor for human consumption. In Article 249 The Parliament has been vested with the power to make laws pertaining to GST on behalf of the state Legislature in circumstances of national interest. The power to make such laws would be pursuant to a resolution passed by the Council of States supported by not less than a two-thirds majority of the members present and voting. Power of Parliament to make laws on subjects in State List in the case of Emergency — Article 250.

The Parliament has been vested with the power to makes laws pertaining to GST on behalf of the State Legislature when there is a proclamation of Emergency.

Functions of the GST Council

The GST Council while being guided by the need for a harmonized structure goods and services tax and for the development of a harmonised national market for goods and services shall make recommendations to the Union and the States on:

  • Taxes, cesses and surcharges levied by the Union and the States and local bodies which may be subsumed within the GST
  • Exemptions from GST for such goods and services
  • Threshold limit of turnover below which GST may be exempted
  • The GST rates
  • Any other matter relating to GST

Every decision of the GST Council taken at a meeting shall be with the consensus of all the members present at the meeting.

Tax Reforms in India

Since the beginning of the last decade as a part of the economic reforms programme, the taxation system in the country has been subjected to consistent and comprehensive reform. The need for the tax reforms arises from the fact that

  • tax resources must maximized
  • international competitiveness must be imparted to the Indian economy
  • transaction costs must be reduced
  • the high-cost nature of Indian economy needs to be corrected so that
  • compliance increases
  • equity improves
  • investment flows

On the direct tax front, the reforms are the following:

Reduction and rationalization of rates- there are only three rates of income tax today with the highest rate at 30%

  • Simplification of procedures
  • Strengthening of administration
  • Widening of the tax base to include more tax payers in the tax net
  • Exemptions are gradually being withdrawn’
  • MAT was introduced for the ‘zero tax’ companies
  • The Direct Tax Code of 2010 is meant to replace the outdated Income Tax Code of 1961.

The important features of a tax haven are:

  • nil or nominal taxes;
  • lack of effective exchange of tax information with foreign tax authorities, that is, personal finance information is not shared with other countries
  • no requirement for a substantive local presence; and
  • self-promotion as an offshore financial center.

Ad Valorem

A Latin term meaning “according to worth,” referring to taxes levied on the basis of value. Taxes on real estate and personal property are ad volorem. Luxury goods are taxed higher even if they weigh the same or number the same as ordinary goods.

Negative income tax

Subsidy is a negative income tax. It is a taxation system where income subsidies are given to persons or families that are below the poverty line. The government will send financial aid to a person who files an income tax return reporting an income below a certain level.

Tax Buoyancy

It refers to the percentage change in tax revenue with the growth of national income. That is growth based increase in tax collections

Pigovian Tax

The Pigovian tax is imposed on bodies that have a negative externality. For example, pollution. Externality means impact of one person’s actions on the well being of an outsider (bystander or third party). For example, the seller and consumer of cigarettes together will harm the third person with pollution. Example of negative externality is exhaust fumes from automobiles. Positive externality refers to a good effect on the third party. For example, restoration of historic buildings, research into new technologies. Carbon tax is one example in the context of the need to discourage fossil fuels and encourage renewable sources due to climate change threat.

Tobin Tax

James Tobin, economist, proposed a worldwide tax on all foreign exchange transactions- when foreign capital enters a country and when it leaves. The aim is to check speculative flows. Long term investment — generally FDI, will not suffer as it does not invest for speculative (short term ) reasons like FIIs

Presumptive Tax

  • Presumptive Tax the Estimated Income Method of assessment for certain categories of businesses is prevalent in several countries. Presumptive taxation involves the use of indirect means to ascertain tax liability, which differ from the usual rules based on the taxpayer’s accounts. The term presumptive is used to indicate that there is a legal presumption that the taxpayer’s income is no less than the amount resulting from application of the indirect method.
  • The reason for the presumptive tax is that in a number of businesses the assesses do not maintain books of accounts or the books of accounts maintained are irregular and incomplete

Capital Gains Tax

  • It is the tax on the gains made from buying and selling assets like land, shares etc.
  • If the gain is made in the assets held for over three year (one year for shares), it is called long term capital gain and taxed. For shares, there is no long term capital gains tax. For short term capital gains (less than one year), it is 15% for shares.


The term cess is generally used to mean a tax. It is an additional levy on a tax. It is different from surcharge as the latter is general while the former is specific. Collections from the latter can be used for any purpose while cess collections can be used for designated ends only- education cess etc.

Direct Taxes Code Bill, 2010

The Direct Taxes Code seeks to consolidate the law relating to direct taxes. The Bill will replace the Income Tax Act, 1961, and the Wealth Tax Act, 1957. The Bill widens tax slabs, and lowers corporate tax rates. It removes a number of exemptions and grandfathers some others.

  • The Bill replaces the Income Tax Act, 1961 and the Wealth Tax Act, 1957.
  • The Bill widens income tax slabs for individuals’ income between Rs 2 lakh to Rs 5 lakh will be taxed at 10%, between Rs 5 lakh and Rs 10 lakh at 20%, and that over Rs 10 lakh at 30%.
  • Companies will be taxed at 30% of business income. Foreign companies shall pay an additional branch profits tax of 15%, Non profit organisations are taxed at 15%.
  • The Bill removes several tax deductions currently allowed for companies, but retains most deductions current available to individuals.
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