SPECIAL ARTICLE December 15, 2007 Economic & Political Weekly 104 The authors have benefited 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 officer 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 figures prominently in India’s plans for fiscal 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, reflecting 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 efficiently 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 filers, 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 efficient 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 verification of information, along with collection of taxes and grievance redressal systems create syner- gies for an efficient 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 efficient tax administration, it becomes very difficult to segregate one from the other, and it also results in difficulty for