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SPECIAL ARTICLE

December 15, 2007 Economic & Political Weekly


104
The authors have beneted immensely from their discussions on the sub-
ject with Amaresh Bagchi, and from the comments by Kalpana Kochhar,
IMF on the draft paper. The error, if any however, is of the authors.
Sanjay Kumar (s.kumar@nic.in) is an ofcer of the Indian Revenue
Service; A L Nagar is a senior consultant, at the Tax Research Cell, National
Institute of Public Finance and Policy (NIPFP), New Delhi; Sayan Samanta
is a project associate at NIPFP.
Indexing the Effectiveness of Tax Administration
Sanjay Kumar, A L Nagar, Sayan Samanta
The capacity of the tax administration needs to be
continuously augmented to keep pace with the
changing requirements of tax policy. One of the key
challenges in this respect is to measure the effectiveness
of the tax administration. This paper develops an
econometric model for indexing the effectiveness of
tax administration by using the principal component
method to remove the feedback effect between
voluntary and enforced compliance. This model
shows that there has not been a large change in the
effectiveness of the direct tax administration in the
country over a period of time, despite the fact that there
has been a substantial increase in the quantum of direct
tax revenue, particularly over the last few years. This calls
for attention to strengthen the tax administration.
T
ax policy and tax administration are inextricably linked
to each other.
1
For the design of a successful tax policy
due attention requires to be paid to removing administra-
tive constraints. Tax reform gures prominently in Indias plans
for scal consolidation. Successive governments have devoted
considerable efforts to developing a tax reform strategy, which
have broadly centred on bringing changes to the tax exemption
level, tax rate structure, and broadening of the tax base [Rao and
Rao 2005]. But despite these policy efforts, the average effective
tax rate has remained low compared to advanced economies,
and also to the higher-income emerging market countries in the
region. The relatively low average effective tax rate in India is
mainly due to low tax productivity, reecting a thin tax base and
widespread tax evasion. This suggests ample scope for increasing
revenue (without raising tax rates), via expansion of the taxpayer
net, lifting exemptions and stepped up tax administration [IMF
2006]. Improved tax administration and compliance often result
in improvement in revenue productivity, and rise in the average
effective tax rate.
2

Improvement in tax administration seeks to secure maximum
tax revenue effectively and efciently given the tax rates. In an
ideal situation, people would pay taxes they owe, and tax admini-
stration would amount to no more than providing facilities for
tax payments. But such situations do not exist. Effective tax ad-
ministration requires an environment in which citizens are in-
duced to comply with tax laws voluntarily. In fact, this is based on
the incentive pattern. If they feel that the non-compliance may
cost more, people would comply with tax laws more. But if the
belief prevails that the cost of non-compliance is not likely to be
high, evasion would be practised with impunity. Thus, the effec-
tiveness of tax administration in fostering compliance would ulti-
mately depend upon the perceived ability to detect and bring tax
offenders, namely, unregistered taxpayers, stop lers, tax evad-
ers, and delinquent taxpayers to book. The tax administration
needs to deal with all these categories of taxpayers simultane-
ously; otherwise non-compliance would shift to the gap where
administration is weak. An efcient tax administration would,
therefore, detect and penalise non-compliance, and facilitate vol-
untary compliance through the provision of quality taxpayers
service. Thus, taxpayers education and service, collection, colla-
tion, storage, retrieval and verication of information, along with
collection of taxes and grievance redressal systems create syner-
gies for an efcient and effective tax administration. Some of
these functions are for encouraging voluntary compliance, and
some for enforcing compliance. Given their synergistic role in
building an efcient tax administration, it becomes very difcult
to segregate one from the other, and it also results in difculty for
SPECIAL ARTICLE
Economic & Political Weekly December 15, 2007
105
the tax administration in assigning a role for its employees tax
enforcer or a tax facilitator.
This paper examines the effectiveness of direct tax adminis-
tration in India through an econometric model, taking into ac-
count tax collections.
3
It constructs a tax enforcement index
treating enforcement as a latent variable through principal com-
ponent analysis, and attempts policy recommendations for im-
proving the efciency and effectiveness of tax administration.
The paper takes tax rates as given. It also does not attempt de-
signing the tax administration; rather focuses only on the effec-
tiveness of tax administration. Section 1 gives a brief description
of the current position of the tax administration, and compares it
to some other countries tax administrations developing and
developed. Section 2 constructs the tax enforcement index.
Section 3 attempts some key policy issues, which would bring a
more effective and efcient tax administration.
1 Current Position of Tax Administration
As stated above, effectiveness of the tax administration would
depend on its ability to detect and bring tax offenders to book.
Some of the main areas of tax offences are un-
registered taxpayers, stop lers, tax evaders,
and delinquent taxpayers.
1.1 Stop Filers
In India, the stop lers are around 10 per cent.
4

The gures (in percentage terms) in Table 1
give a comparative chart of the stop lers, ex-
isting taxpayers and new taxpayers over the
last ve nancial years.
It may also be stated here that these g-
ures may not be entirely correct, because the
permanent account number (PAN)
5
database
(particularly, for the personal income taxpay-
ers) has not been very accurate. Most of the tax
districts,
6
till late, have been maintaining an
individual database manually, and so, if any
taxpayer shifted from one tax district to an-
other, there was no mechanism to verify this,
unless the taxpayer himself reported doing so.
Otherwise, he would be reported as a stop ler
in one district, and a new taxpayer in another.
Besides this, a number of taxpayers had two or
more PANs out of volition or out of confusion.
This also led to double counting.
On the corporate taxpayers side, companies
are mandatorily required to le returns of
income as per the income tax laws.
7
As on
October 31, 2004, 6,61,371 companies were
under registration in the country,
8
but the
records of the income tax department show
that only 3,72,483 returns were led. This
shows that about 44 per cent of the companies did not le corpo-
rate tax returns.
While the reasons for high percentage of stop lers or inac-
curacy of the data above may be debated, it is certainly true that
there needs to be substantial improvement in order to develop an
efcient tax administration. The reason that the taxpayers reg-
ister is out of date highlights that the tax administration is not
dealing with stop ling taxpayers in a systematic manner, and
needs to design an adequate strategy.
1.2 Delinquent Taxpayers
Priorities are often set for controlling delinquent taxpayers.
9
Tax
administrations normally have sufcient legal provisions avail-
able to take swift and effective action against the delinquent
taxes. Though many times such non-payments of taxes are not
due to lack of effort on the part of tax administration, they may also
be for the reasons that the tax demands may be in dispute before
the courts, which sometimes take an inordinately long-time to
decide on the tax demands. Also, sometimes the taxpayers le
appeals the court decisions and take the cover of the tax demand
under dispute as the reason for not paying taxes. That apart,
reasons such as raising infructuous demand due to lack of evi-
dence, collusion between tax enforcers and taxpayers, double
counting of the tax demand, etc, also cannot be ruled out.
Whatever be the reason, delinquent taxes
in India have shown a steady rise from
Rs 22,928 crore in 1995-96 to Rs 98,612 crore
in 2005-06, implying a compounded annual
growth rate of 30 per cent. Compared to that,
the percentage collection of these arrear
demands have remained static between 8 and
9 per cent the only rise was in the nancial
year 1999-2000 when the government intro-
duced a scheme for settling tax arrears. These
outstanding arrears, as can be seen, are almost
equal to or a high percentage of the annual
tax collections.
The gures show that the arrear demand
collection has remained at over as a percent-
age of the total collection during the last nine
years, indicating that there has not been any
perceptive change in the effort of the tax ad-
ministration towards collecting arrears. But
what needs to be realised is that often lax at-
tention to tax delinquency can be an expen-
sive source of nancing for the government,
and easy and cheap source of nance for the
taxpayer.
It is often seen that a small percentage of
delinquent taxpayers account for a large per-
centage of delinquent taxes. Statistics from
Latin American countries show that 3 to 12 per
cent of delinquent taxpayers accounted for 65
to 90 per cent of delinquent taxes. Such a
pattern of high delinquent taxes being as-
cribed to a small percentage of taxpayers
also exists in India. Quick estimates show that close to 80 per
cent of the delinquent taxes involve only 200 taxpayers. Such
high concentration of arrears in a few taxpayers requires a set of
arrear collection priorities.
Table 1: Comparing Stop Filers, Existing
and New Taxpayers (in %)
Year Stop Filers Existing New
Taxpayers Taxpayers
2000-01 12.31 71.91 15.78
2001-02 6.87 71.90 21.23
2002-03 17.70 77.46 4.84
2003-04 16.35 78.18 5.47
2004-05 3.39 89.62 6.99
Source: Income tax department, government of India.
Table 2: Arrear Demand Collection
for Income and Corporate Tax (in Rs crore)
Financial Arrear Cash Percentage
Year Demand Brought Collection Collection
Forward as on Out of Arrear
March 31 Demand
1995-96 22,928.61 2,079.01 9.07
1996-97 29,221.49 2,328.41 7.97
1997-98 33,925.47 2,845.04 8.39
1998-99 45,039.95 3,049.47 6.77
1999-2000 43,868.78 30,066.60 68.54
2000-01 51,472.55 4,991.91 9.70
2001-02 49,222.85 3,938.89 8.00
2002-03 73,012.85 5,499.25 7.53
2003-04 72,347.88 5,540.23 7.66
2004-05 92,886.00 7,084.00 7.63
2005-06 98,612.00 8,064.00 8.18
Source: CBDT.
Table 3: Collection of Personal Income Tax
(as % of total collection)
Year Pre-assessment Post-assessment
Collection Collection
1995-96 82.6 17.4
1996-97 82.6 17.4
1997-98 85.6 14.4
1998-99 82.4 17.6
1999-2000 79.5 20.5
2000-01 83.1 16.9
2001-02 84.2 15.8
2002-03 87.7 12.3
2003-04 85.3 14.7
Source: CBDT.
SPECIAL ARTICLE
December 15, 2007 Economic & Political Weekly
106
Table 4: Matrix (R) of Correlations between Various Components of Income Tax
Components of IT TDS Advance Regular Penalty 1 Penalty 2 Interest Refunds Other
Tax Assessment Recoveries Receipts
TDS 1.0000
Advance tax 0.9545 1.0000
Regular assessment 0.8884 0.9510 1.0000
Penalty 1 0.1759 0.2716 0.1899 1.0000
Penalty 2 0.7892 0.6638 0.5753 0.1454 1.000
Interest recoveries 0.7837 0.8101 0.6510 0.6579 0.6037 1.0000
Refunds 0.1295 0.3014 0.3590 -0.1116 -0.0233 0.0398 1.0000
Other receipts -0.0629 0.1547 0.2737 -0.1250 -0.2598 -0.1545 0.6578 1.0000
Table 5: Matrix (R) of Correlations between Various Components of Corporate Tax
Components of CT TDS Advance Regular Penalty 1 Penalty 2 Interest Refunds Other
Tax Assessment Recoveries Receipts
TDS 1.0000
Advance tax 0.8352 1.0000
Regular assessment 0.8682 0.9774 1.0000
Penalty1 -0.0609 -0.0487 -0.0727 1.0000
Penalty 2 0.3011 0.6165 0.5939 0.0631 1.0000
Interest recoveries 0.2220 0.5480 0.5318 0.1393 0.3635 1.0000
Refunds 0.9983 0.8420 0.8666 -0.0468 0.3120 0.2176 1.0000
Other receipts -0.1165 -0.0646 -0.0707 -0.3301 -0.1426 -0.2081 -0.1237 1.0000
1.3 Tax Audit
It is widely recognised that taxpayers perception of the probabi-
lity of being audited strongly determines their degree of compli-
ance. Thus, the importance that a tax administration assigns to
the audit function greatly affects the ability of the organisation to
enforce compliance. Even if a tax administration is very effective
in registering taxpayers and detecting stop lers or delinquent
taxpayers, the administrations overall effectiveness will be low
if auditing is not effective in discouraging evasion.
In India, the taxpayer provides information to the tax admin-
istration through returns and accompanying documents. These
returns contain valuable information on the taxpayer and his
activities. All this information is potentially used to help gauge
the taxes due from taxpayers. Besides is, information is also col-
lected through various information returns, which
are collected from the third parties on various in-
vestments or expenditures. Though a wide variety
of sources of information can be imagined for col-
lecting such information, the challenge of match-
ing this third party information and collating it in a
useful form is certainly a task.
If we see the collection of personal income tax
pre-assessment and post-assessment, as percent-
age of total collection, we nd that there has not
been any signicant change in the tax collection
pre-assessment or post-assessment; in fact it has
remained stagnant. This shows that despite the
emphasis of the tax administration on improving
the collection of information, the effectiveness of
the use of information has not seen any signicant
improvement. Maybe the audit programmes, which
are reported to be auditing 2-3 per cent of the tax
returns are not able to control the underreporting
of taxes!
A comparison with some of the Organisation for
Economic Cooperation and Development (OECD)
tax administrations shows that the Indian tax
administration is collecting signicantly higher
post-assessment taxes as percentage of total collec-
tions. But there is no reason for complacency on
this score as the OECD has better socio-economic
conditions, social security systems, and better
governance systems, which result in higher volun-
tary tax compliance.
A good indicator of the emphasis on the audit
function is the number of employees engaged in
audit work in any tax administration. In OECD countries, audit,
investigation and other verication functions are, on an average,
carried out by more than 25 per cent of the employees. Australian
tax administration has 33.8 per cent employees in audit, investi-
gation and other verication functions; Belgium 50 per cent, the
US 18 per cent, Japan 68.4 per cent, Turkey 10.7 per cent and UK
13.9 per cent [OECD 2006]. In non-OECD countries like Argentina,
the ratio of employees employed in audit and other verication
functions is reported to be 34.4 per cent, Chile 60.2 per cent,
such percentage deployment in India is not known.
But an estimate of the deployment in India, taking into account
the fact that each tax ofcer handles 150 cases every year on an
average for audit, with a complement of four staff members on an
average, shows that each employee handles the audit work of 37.5
cases. If we see the number of assessments per employee in
other countries developed and developing, we nd that there is
a denite pattern for deployment of employees for tax audit work.
In Australia it is 4.58, US 1.16, Canada 4.04, South Africa 29.23,
Turkey 11.28, Argentina 32.28, Chile 90.18 [OECD 2006]. Thus,
developing countries, typically, have a large number of cases be-
ing handled by each employee. Developed countries employees,
on the other hand, handle a lesser number of cases, and so are
able to devote a considerably longer period of time to create
deterrence through tVe tax audits.
An overview of the tax audit programme of developing coun-
tries shows that these countries typically experience some im-
provement in compliance and collection in the short-term but
they tend to reach plateau within a few years after the rst drastic
changes are introduced and do not show any signicant advances
subsequently. This means that the tax administration needs to
focus on its audit efforts by improving its information collec-
tion, collation, and dissemination in a concerted manner. But
the dilemma of whether the tax administration should engage its
employees as tax enforcers or tax facilitators continues to affect
Table 6: Arithmetic Mean and Standard Deviations of Observations on Variables
TDS Advance Regular Penalty 1 Penalty 2 Interest Refunds Other
Tax Assessment Recoveries Receipts
IT
Mean
`
x 99991727 43944471 9439298 55653 398761.7 684776.1 4.6E+07 243487
Standard deviation s
x
97237562 26096827 6482895 140906 718993.4 699472.7 4.8E+07 472321
CT
Mean
`
x 51657666 1.44E+08 37865022 59162.6 120306 3837706 8.2E+07 166036
Standard deviation s
x
75686343 1.35E+08 35989010 93511.5 162500 6500979 1.36E+08 253484
Table 7: Eigenvalues (l
i
) for Income Tax and Corporate Tax
(l
1
) (l
2
) (l
3
) (l
4
) (l
5
) (l
6
) (l
7
) (l
8
)
IT 4.2573 1.9068 1.0486 0.3854 0.2638 0.1186 0.0131 0.0064
CT 4.2198 1.4459 0.9836 0.6552 0.6241 0.0503 0.0203 0.0007
SPECIAL ARTICLE
Economic & Political Weekly December 15, 2007
107
such efforts. In fact, in many countries, it has been seen that the
auditing has decreased in importance over a period of time rela-
tive to other tax administration functions, as shown by the reduc-
tion in the number of staff assigned to auditing as well as by the
decrease in the percentage of taxpayers who are audited.
2 Voluntary Compliance and Enforcement Measures
Given the above perspective, it would be in order to examine the
effectiveness of tax administration and attempt to construct an
index to estimate the contribution of voluntary compliance and
the enforcement measure.
2.1 Tax Enforcement
In common parlance, involuntary payment of taxes is linked to
tax enforcement. But enforcement acts through two channels;
directly, as involuntary collections are enforced by tax
admini stration, and indirectly, as voluntary compliant tax pay-
ments, induced by fear of enforcement actions. Efcient enforce-
ment should have minimum actions, which can lead to a higher
share of voluntary compliance relative to potential or theoretical
maximum tax collections. This would also mean that voluntary
compliant taxes should have a high share in the total tax collec-
tions. A less efcient system would be one where a high share of
collections requires strong enforcement actions. It also needs to
be mentioned here that the efciency of tax enforcement actions
is not a stand-alone parameter; rather it also depends on the syn-
ergistic relationships with other institutions in the economy, such
as the responsiveness of the legal structure, trust in rule of law,
and other social institutions.
The term tax enforcement implies tax collection as per the
statute of the tax laws. Taxes are to be paid according to the
rules and provisions of the law, which are administered by the
tax administration. Penalties are imposed for any lapses (either
late payment or detection of undisclosed income) on the part of
taxpayers. Various components of tax collection include (i) taxes
deducted at source (TDS); (ii) advance tax payments; (iii) taxes
paid on regular assessments; (iv) penalty 1 for detection of un-
disclosed income, under Section 271(1)(c) of the Income Tax Act
1961; (v) penalty 2 other than those under (iv); (vi) interest
recoveries either for less payment or late payment of taxes; and
(vii) other receipts, in the nature of residuary receipts.
Any excess payment of taxes results in refund of the taxes.
All tax payments are mandatory. But for convenience, one
may classify them as, voluntary and involuntary payments.
TDS and advance tax payments can be largely regarded as vol-
untary, as they are paid by taxpayers before they submit any
return of income.
10
Involuntary payments are those arising out
of regular assessment (such as, penalties 1 and 2, interest recov-
eries, refunds and other receipts, including taxes paid on regular
assessments).
2.2 Tax Enforcement Index
In this section, we propose to construct a tax enforcement index
(ENF) for corporate tax (CT) and income tax (IT) as a weighted
average of various tax components, based on the time series data
(1985-86 to 2003-04) on various tax components available from
published sources, such as The Statistical Abstract of India.
It should be noted that the tax components (i) to
(vii) are not mutually uncorrelated. Pair-wise
correlations between them are given in Tables 4
and 5 (p 106).
We observe that corr (TDS, advance taxes) is of
the order of 0.9545 for IT and it is 0.8352 for CT.
The correlation between TDS and regular assess-
ment is of the order of 0.8884 for IT and it is
0.8682 for CT; and so on. It is, therefore, not appro-
priate to pick one of the components (say TDS or
regular assessment, etc) and analyse the effect of
changes in them on the enforcement or perform-
ance of tax collection. There is need to compute a
composite index of enforcement by combining
various tax components in a suitable way (assign-
ing appropriate weights to different components) and relate it to
the tax productivity of the economy.
While constructing the ENF as a weighted average of various
tax components, it is crucial to determine weights to be assigned
to each of these components. We propose a method of deter-
mining the weights that take into account the variation in tax
components over the entire period of observations, viz, 1985-86
to 2003-04.
We regard ENF as a latent
variable, which cannot be
measured in a straight for-
ward manner but is sup-
posed to be linearly deter-
mined by various tax com-
ponents. Supposing that
we have an adequate set of
tax components (deter-
minants of ENF), we can
assume that the total varia-
tion in ENF over years is
accounted for by the varia-
tion in various tax compo-
nents and error variance is
negligible. We exploit the
total variation in all tax
Table 8: Eigenvectors for Income Tax and Corporate Tax
(a
1
) (a
2
) (a
3
) (a
4
) (a
5
) (a
6
) (a
7
) (a
8
)
IT 0.4651 0.0309 -0.2360 -0.1226 -0.1355 -0.0785 0.6819 0.4717
0.4728 -0.1054 -0.0423 -0.1834 -0.1622 -0.0733 0.1612 -0.8199
0.4399 -0.2046 -0.0759 -0.3367 -0.1061 0.5820 -0.4918 0.2315
0.1882 0.2667 0.8069 0.0919 0.2066 0.3609 0.2466 -0.0126
0.3719 0.1925 -0.3611 0.4605 0.6791 0.0479 -0.1241 -0.0577
0.4250 0.1914 0.3038 0.0732 -0.1910 -0.6504 -0.4311 0.1996
0.1100 -0.6137 0.1175 0.7050 -0.2968 0.0939 0.0459 0.0379
0.0156 -0.6516 0.2217 -0.3392 0.5618 -0.2922 0.0551 0.0831
CT -0.4371 -0.1764 -0.3755 -0.0361 0.0469 -0.3885 -0.0312 0.6939
-0.4758 -0.0378 0.1111 -0.0612 0.0217 0.6537 0.5564 0.1371
-0.4794 -0.0604 0.0731 -0.0329 0.0332 0.3342 -0.7940 -0.1303
0.0073 0.6390 -0.2676 -0.7189 0.0190 0.0438 -0.0298 0.0067
-0.2955 0.2048 0.4791 -0.0393 -0.7374 -0.3059 0.0483 0.0039
-0.2582 0.3579 0.5021 0.1239 0.6581 -0.3165 0.0661 -0.0122
-0.4383 -0.1668 -0.3785 -0.0463 0.0283 -0.3165 0.2263 -0.6946
0.0817 -0.5980 0.3806 -0.6767 0.1351 -0.1196 0.0153 -0.0053
Table 9: Proportion of Variation Accounted
for by Successive Principal Components
Variance of P
i
Proportion Cumulative
of Variance Proportion of
Accounted (%) Variance
Accounted (%)
IT
4.2573 53.2163
1.9068 23.8350 77.0513
1.0486 13.1075 90.1588
0.3854 4.8175 94.9763
0.2638 3.2975 98.2738
0.1186 1.4825 99.7563
0.0131 0.1638 99.9200
0.0064 0.0800 100
CT
4.2198 52.7482
1.4459 18.0740 70.8221
0.9836 12.2952 83.1173
0.6552 8.1901 91.3074
0.6241 7.8013 99.1087
0.0503 0.6288 99.7375
0.0203 0.2538 99.9912
0.0007 0.0088 100
SPECIAL ARTICLE
December 15, 2007 Economic & Political Weekly
108
components to arrive at the ENF index.
For this purpose, we construct principal components (dened
as normalised linear combinations) of various tax components,
which have the property that the rst principal component (P
1
)
accounts for the largest proportion of total variation in all tax
components, the second principal component (P
2
) accounts for
the second largest proportion of total variation in all tax compo-
nents, and so on. If we compute as many principal components as
the number of tax components, the total variation in all tax com-
ponents is accounted for by all principal components together.
It is also true that the corr (P
i
, P
j
) = 0, i e, the principal compo-
nents are mutually orthogonal.
11

A weighted average of the principal components

l
1
P
1
+
. . .
+ l
k
P
k
ENF = denes the tax enforcement index.
l
1
+ ... + l
k
In the present case, k = 8 and l
1
> l
2
>
. . .
> l
8
are successive
eigenvalues of the 88 correlation matrix of observations on
various tax components. We have arranged them in descending
order of magnitude.
It can be shown that Var P
1
= l
1
,
. . .,
Var P
1
= l
8
.
We assign largest weight l
1
/ S l
1
to P
1
because it accounts for
the largest proportion of total variation in all tax components.
Similarly P
2
has been assigned the second largest weight l
2
/ S l
i

because it accounts for the second largest proportion of the total
variation in all the tax components, and so on.
By a little rearrangement of terms, the ENF index can be ex-
pressed as a weighted sum of various tax components which pro-
vides weights (share) of individual tax components.
2.3 Computation of ENF Index
Since we are using an aggregated database, the magnitudes of
observations on different components are very high (or, very
low). For example, for IT, TDS in 2003-04 is Rs 3,01,57,77,64,000,
advance tax in this year is Rs 97,09,51,01,000 and penalty 1 is
Rs 2,16,42,000, etc. It is advisable to make the observations scale
free. We transform the variables into their standardised form by
subtracting respective arithmetic means (AM) from each obser-
vation and dividing them by the standard deviation (SD). The
arithmetic means and standard deviations of observations on the
tax components are given in Table 6 (p 106).
The covariance matrix of standardised variables is, in fact, the cor-
relation matrix between the components as given in Tables 4 and 5.
We compute the eigenvalues shown in Table 7 (p 106), of the
cor relation matrix R for IT and CT by solving the determinant
equation |R lI| = 0.
Corresponding to each eigenvalue (l
i
), we solve the matrix
equation (R l
i
I) a
i
= 0 to obtain the 81 eigenvector
a
i
=
.
8 i
2 i
1 i
i

a
a
a
= a


as shown in Table 8 (p 107).
The principal components of tax components are obtained as
normalised linear functions of standardised variables, where the
coefcients are elements of successive characteristic vectors.
Thus, the rst principal component for IT is:
TDS
t
99991727 AT
t
43944471
P
1t
= 0.4651
(

)
+0.4728
(

)
97237562 26096827
RA
t
9439298 PEN1
t
55652.59
+ 0.4399
(
) +0.1882
(

)
6482895 140906
PEN2
t
718993.4 IR
t
699472.7
+ 0.3719
(

)
+0.4250
(

)
2764113 2466368
REF
t
45808282 OR
t
243487.1
+ 0.1100
(

)
+0.0156
(

)
47585682 472320.8
For CT, it is:
TDS
t
51657666 AT
t
1.44E+08
P
1t
= 0.4371
(

)
0.4758
(

)
75686343 1.35E+08
RA
t
37865022 PEN
t
1 59162.58
0.4794
(

)
+0.0073
(

)
35989010 93511.47
PEN2
t
120306 IR
t
3837706
0.2955
(

)
0.2582
(

)
162499.6 6500979
REF
t
82390160 OR
t
166036.2
0.4383
(

)
+0.0817
(

)
1.36E+08 253484.3
The normalisation is such that the sum of squares of coef-
cients is 1.
The values of principal com ponents, for CT and IT for different
years, are obtained by substituting the corresponding values of
the indicators of tax enforcement.
The variance of successive principal components (equal to the
eigen values), proportion of total variation accounted for by them
and cumulative proportion of variation explained are given in
Table 9 (p 107).
From Table 9,
we observe that
53.21 per cent of
the total variation
in all tax com-
ponents of IT is
accounted for by
the rst principal
component alone;
77.05 per cent of
the variation is ac-
counted for by the
rst and second
principal compo-
nents and so on.
Similarly, 52.75
per cent of the to-
tal variation in all
tax components of CT is accounted for by the rst principal com-
ponent; 70.82 per cent of the total variation is accounted for by
the rst and second principal components, etc.
All eight principal components account for 100 per cent of the
total variation in all tax components. Table 10 provides the esti-
mated tax enforcement index calculated as

l
1
P
1
+
. . .
+ l
8
P
8
ENF = for the time period 1985-86 to 2003-04.
l
1
+ ... + l
8
Table 10: Tax Enforcement Index of IT and CT
Income Tax Corporate Tax
Year Index Revised Year Index Revised
Index Index
1999-00 2.51 102.51 2003-04 3.70 103.7
2002-03 2.13 102.13 2002-03 1.36 101.36
2003-04 1.50 101.5 2001-02 1.15 101.15
2000-01 1.18 101.18 1998-99 0.34 100.34
2001-02 1.11 101.11 2000-01 0.23 100.23
1998-99 0.07 100.07 1999-2000 0.20 100.2
1996-97 -0.11 99.89 1997-98 0.10 100.1
1994-95 -0.37 99.63 1996-97 -0.01 99.99
1995-96 -0.38 99.62 1995-96 -0.05 99.95
1997-98 -0.47 99.53 1994-95 -0.33 99.67
1993-94 -0.56 99.44 1993-94 -0.42 99.58
1992-93 -0.68 99.32 1991-92 -0.61 99.39
1989-90 -0.72 99.28 1992-93 -0.61 99.39
1990-91 -0.76 99.24 1990-91 -0.74 99.26
1991-92 -0.76 99.24 1988-89 -0.75 99.25
1988-89 -0.85 99.15 1989-90 -0.76 99.24
1987-88 -0.93 99.07 1987-88 -0.86 99.14
1985-86 -0.95 99.05 1986-87 -0.90 99.1
1986-87 -0.97 99.03 1985-86 -1.02 98.98
The revised index is obtained by choosing 100 for the zero value of the index.
SPECIAL ARTICLE
Economic & Political Weekly December 15, 2007
109
Table 11: Weights (Share) of Individual Tax
Components (%)
Tax Components IT CT
TDS 16.94 25.62
Adv Tax 16.94 19.83
Regular assessment 12.90 20.66
Penalty 1 23.39 -2.48
Penalty 2 19.35 9.92
Interest recovery 24.19 -4.13
Refunds -4.03 25.62
Other receipts -9.68 4.96
Total 100 100
Table 12: Weights (Share) of Individual Tax
Components (%)
Tax Components IT CT
TDS 27.64 26.97
Adv tax 23.52 21.40
Regular assessment 20.50 22.71
Penalty 28.38 7.75
Interest recovery 23.43 -3.59
Refunds -12.82 27.02
Other receipts -10.66 -2.27
Total 100 100
Rearranging terms in ENF, we obtain the coefcients of indi-
vidual tax components as given below:
For IT: 0.21 TDS +0.21 AT + 0.16 Reg asst + 0.29 Penalty 1 + 0.24
Penalty 2 + 0.30 Int recovery 0.05 Refund 0.12 other receipts.
For CT: 0.31 TDS + 0.24 AT + 0.25 Reg asst 0.03 Penalty 1 + 0.12
Penalty 2 - 0.05 Int recovery + 0.31 Refund + 0.06 other receipts.
The sum of the coefcients in ENF for IT is 1.24. Therefore,
weight (share) of TDS for IT is obtained as
(0.21/1.24) 100 = 16.94 per cent and so on
for other tax components of IT. Similarly,
sum of coefcients in ENF for CT is 1.21. There-
fore, weight (share) of TDS for CT is (0.31/1.21)
100 = 25.62 per cent, etc.
Table 11 gives weights (shares) of individual
tax components.
The above results show that TDS and ad-
vance tax, broadly considered voluntary tax
payments, contribute 33.88 per cent and 45.45
per cent of the tax enforcement in IT and CT, re-
spectively. Involuntary compliance resulting
out of regular assessment, levy of penalty, inter-
ests recoveries, etc, constitute the remainder.
While for personal income tax, the pen-
alty under Section 271(1) (c) is really a threat
against the taxpayer with 23.39 per cent of
the weight share in the enforcement index, it is
not a very effective enforcement measure against the corporates.
It should be observed that the magnitude of penalty 1 has re-
mained rather low for all years except 1999-2000 (showing a
peak). For CT, the year 1985-86 was really an outlier with respect
to penalty 1, as also 1998-99 showing a high value of penalties 1
besides 1999-2000 showing the peak.
As involuntary compliance results mainly from regular assess-
ment, the relationship between penalty 1 and regular assessment
is important. From Table 2 (p 105) we see that for CT the cor-
relation between regular assessment and penalty 1 is negative
(equal to 0.07). In fact, this is insignicant correlation.
If we combine penalties 1 and 2 the weight shares are as shown
in Table 12.
3 Conclusions
From the above analysis we nd that the voluntary compliance is
not more than 50 per cent in IT or CT. Close to one-fth of the
enforcement comes from regular assessment. Penalties on indi-
vidual taxpayers do act as a deterrent but such an effect is not
very perceptible in the case of corporate taxpayers. Since re-
funds, in the case of corporate taxpayers, are large due to the
high volume and magnitude of the disputed amount against
them, the enforcement index presents it as an important factor in
raising tax collection. In fact, it is said that till some years ago the
interest rates on refunds were high and many corporate taxpay-
ers were nding an opportunity for arbitrage on the interest rates
and therefore, were making higher instalment payments, only to
collect them later as refunds. Since such refunds are not so high
in personal income tax, they show up having negative effect on
the tax enforcement index.
Given the above and the fact that the tax enforcement index
have hovered around the same level, the deviation being low, it
is important that the tax administration improves each of the
key components of tax enforcement voluntary as well as invol-
untary. Since the two components of tax enforcement have a
feedback effect on each other, one cannot be improved at the
expense of the other. Each aspect of the tax administration, like
detecting stop-lers, penalising tax evaders,
and making delinquent taxpayers pay arrears,
bringing unregistered taxpayers to the tax fold
are important for creating an efcient and
effective tax administration. But as already
stated, it is also important that the tax depart-
ment focuses on facilitating voluntary compli-
ance through the provision of quality taxpay-
ers service. Important obstacles to taxpayers
voluntary compliance are the perceived in-
equity of the tax system, complexity of tax
laws, lack of fairness of the penalty system,
and weak taxpayer education programmes.
Lack of adequate training of the staff, the tax
administrations inability to ensure adequate
follow-up action during the appeal process,
and weak tax audit programmes act as impedi-
ments to the enforced compliance. Well-
designed preventive actions, such as the estab-
lishment of withholding schemes and development of preven-
tive audit programmes which will demonstrate to a signicant
number of taxpayers that the tax administration will use relevant
information from third parties to detect evasion, may also foster
voluntary compliance.
One key strategy to improving the effectiveness of administra-
tion would be to build a proper information system, and a data
base. A major aspect of poor tax administration has been the
virtual absence of data, and if there is data, it is inadequately
collated for meaningful analysis. This has not only rendered the
proper analysis of taxes to provide an adequate analytical back-
ground to calibrate changes in the tax structure but it has also
made enforcement difcult. Changes in the tax structure have
often been made in an ad hoc manner [Rao and Rao 2005]. High
compliance costs combined with the poor state of computerisa-
tion and information systems have led to a continued interface of
taxpayers and tax ofcials, with compliance costs but low levels
of tax compliance [Das-Gupta 2004]. An important indication of
the poor state of information system is that even as the coverage
of TDS was extended over the years, there was virtually no
1985-86 1990-91 1995-96 2000-01 01-02 02-03 03-04
Figure: Fluctuation in ENF Index for Income Tax and Corporate Tax
96
97
98
99
100
101
102
103
104
105
1985-86 1990-91 1995-96 2000-01
I
n
d
e
x
Year
CT
IT
SPECIAL ARTICLE
December 15, 2007 Economic & Political Weekly
110
Notes

1 A tax policy is only as good as it is administered and there-
fore, it is importan
t to design the tax system keeping the
administrative capacity in mind [Bird and Zolt 2005].
2 Revenue productivity is a ratio of the effective tax rate
to statutory tax rate. For example, statutory corporate
tax (CT) rate in India in 2001 was 35.9 per cent and
the effective CT rate was 3.5 per cent, so the revenue
productivity was 9.7 = (
3.5
/35.9) 100. Ratio of corpo-
rate tax to GDP is used for calculating effective CT rate.
For comparison with other countries, see the table below.
3 This paper deals with only the direct taxes personal
income tax and corporate tax, which is collected by
the income tax department, government of India.

4 Stop lers are those taxpayers, who after paying tax-
es for one or more years stop ling their tax returns.
In many counties, the ratio of stop-ling taxpayers to
the total registered taxpayers is in the range of 20 to
40 per cent.

5 PAN is a taxpayers identication number.
6 Commissioners jurisdiction is called a charge.
7 See Section 139(1)(a) of the income tax act.
8 Government of India, Ministry of Company Affairs
web site.
9 Delinquent taxpayers are those who despite having
taxes due from them have not paid them. This may be
for various reasons, creating arrears.
10 The income tax act has provisions under Section 210
to even enforce such voluntary advance tax pay-
ments.
11 We can draw an analogy with the classical regres-
sion model. If the dependent variable (ENF) could
be measured, we would simply run a least squares
regression of ENF on various tax components and
determine optimal coefcient estimates. The total
variation in ENF is expressed as a sum of (i) variation
due to tax components and (ii) error variance. How-
ever, as corr (P
i
, P
j
) =0, the tax components are not
necessarily mutually uncorrelated.
References
Bird, Richard M and Eric M Zolt (2005): Redistribution
via Taxation: The Limited Role of the Personal Income
Tax in Developing Countries, Andrew Young School of
Policy Studies, Georgia State University.
Das-Gupta, Arindam (2004): Compliance Cost of the Per-
sonal Income Tax in India, 2000-01: Preliminary
Estimates, National Institute of Public Finance and
Policy.
Poirson, Helene (2006): Making Tax Policy Pro-growth,
India Goes Global, IMF, Washington DC.
OECD (2006): Tax Administration in OECD and Selected
Non-OECD Countries: Comparative Information Se-
ries, 2006, Centre for Tax Policy and Administration.
Rao, M Govinda and R Kavita Rao (2005): Trends and
Issues in Tax Policy and Reform in India, Working
Paper No 13, National Institute of Public Finance and
Policy.
Revenue Productivity (%)
Country Effective Statutory Revenue
Tax Rate (%) Tax Rate (%) Productivity
France 8.9 33.3 26.73
Germany 2.1 38.9 5.40
Italy 6.7 37 18.11
Japan 8.7 40.9 21.27
Korea 9.6 29.7 32.32
UK 9.9 30 33.00
US 5.3 45.8 11.57
OECD average 9.6 32.3 29.72
Source: Helene Poirson (2006).
information system to check whether those deducting the tax at
source le the returns and pay tax. As the CAG report for 2003-
04 states that of the 6,26,000 returns to be led by TDS assesses,
only 4,99,000 returns were led (ibid). In other words, more
than 20 per cent of the TDS assesses did not le the returns.
The recent initiative of the Central Board of Direct Taxes on
building the computerised information system may facilitate
compiling information on taxpayers. This would improve match-
ing and cross-checking of information from banks and other
sources, and may improve voluntary compliance. The online tax
accounting system operationalised in July 2004, may be one such
step in that direction. The current high growth rate in the direct
taxes should not be a reason for complacency if the effective-
ness of the tax administration is to be improved. In fact, in-
creased effectiveness of the tax administration would actually be
reected in the increased voluntary compliance. Penalising tax
evaders and pursuing delinquent taxpayers to collect tax arrears
cannot be the main objectives of an effective tax administration;
rather it should be to encourage voluntary compliance so that if
marginal non-compliance is detected, the same is effectively
punished. There is, therefore, a need to manage the tax admini-
stration with a view to achieving a proper balance between the
service to the taxpayer and enforcement of the tax laws to pro-
mote voluntary compliance.
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