Financing Growth through Tax Reforms:
A Constructive Journey

Prof. R Kavita Rao
Director
National Institute of Public Finance and Policy (NIPFP)

Recognising states that demonstrate exemplary work in governance and development plays a crucial role in strengthening India’s growth story. By presenting successful initiatives as models for others to emulate, such recognition builds a culture of healthy accountability and continuous improvement. It also reflects the essence of democracy and federalism—systems that thrive on negotiation, shared responsibility and the collective will to pursue national progress.

In this environment, one of the most pressing questions concerns the financing of growth and development. India’s federal structure is distinctive: while the Centre collects a large share of revenues, the states shoulder the bulk of expenditure. In numerical terms, states raise around 35 percent of revenues but are responsible for nearly 60 percent of total government spending. Increasingly, they are tasked with preparing ambitious growth visions aligned with the goal of a Viksit Bharat, making the financing question unavoidable. Borrowing provides only limited space, constrained as it is by fiscal responsibility laws. The answer, therefore, circles back to taxation—the most durable foundation of public finance.

India’s Revenue Journey

India’s revenue effort over the past four decades reveals both progress and challenges. The tax-to-GDP ratio has improved from less than 14 percent in the early 1980s to about 18.5 percent today. This represents a nearly five percentage point rise over 45 years—a notable achievement given the complexities of a developing, diverse and large federal economy.

States have steadily improved their own tax revenues, which have grown from just above 4 percent of GDP in 1980 to around 7 percent today. By contrast, the Centre—despite collecting about two-thirds of the country’s total revenues—has experienced greater volatility. Periods of buoyancy have been punctuated by sharp downturns, reminding policymakers that reforms must be consistent and that resilience requires diversification of the base.

The broader lesson is constructive: reforms and stronger administration, pursued patiently over time, can deliver enduring improvements. Yet, as expenditure demands continue to expand—whether for infrastructure, social protection, or human capital development—further strengthening the revenue system becomes essential.

Milestones in Reform

India’s fiscal history is marked by several critical reform phases, each bringing lessons and building blocks for the future.

• 1987: MODVAT – The introduction of Modified Value Added Tax (MODVAT) marked a significant step toward reducing cascading in indirect taxation. By allowing tax credits, the system improved efficiency and transparency. While it naturally capped revenue collections, it laid the groundwork for a more modern system that prioritised fairness and neutrality.
• 1991: Chaliah Committee Reforms – The reforms recommended by the Chaliah Committee were transformative. Income tax slabs were rationalised, reducing complexity from many tiers to just four. Peak income tax rates were lowered. Customs duties were sharply brought down to promote competitiveness and efficiency. While these measures improved economic dynamism, they did not immediately translate into higher tax-to-GDP ratios. This highlighted a crucial lesson: efficiency gains and economic growth do not automatically lead to proportionate revenue increases.
• 2001–2007/08: An Outlier Period – The early 2000s witnessed unusually high growth, accompanied by sharp increases in corporate tax collections. Much of this buoyancy was linked to improvements in tax administration, particularly IT-driven innovations. The adoption of technology enhanced compliance and monitoring, enabling the system to capture revenue more effectively. The result was a strong upward trend in the tax-to-GDP ratio during this phase, demonstrating the power of administrative reform alongside policy change.
• 2007–2008 and After: Crisis and Stabilisation – The global financial crisis necessitated macroeconomic stabilisation measures. Excise duty rates were reduced to stimulate demand, which naturally lowered revenues. Thereafter, the tax-to-GDP ratio fluctuated around a broad trend rather than showing consistent upward momentum.
• 2017–2018: Introduction of GST – The Goods and Services Tax represented a landmark structural reform aimed at creating a unified and efficient system. Intended to be revenue-neutral, GST’s early years saw transitional challenges. Initial revenue performance fell short of neutrality, compounded by the disruption of COVID-19. Yet, GST remains a powerful tool for simplification and efficiency, offering long-term promise for widening the base and reducing distortions.
• 2019: Alternative Tax Regimes – A dual framework was introduced in corporate and personal income taxation. Taxpayers were given a choice between regimes with higher rates and exemptions or simplified regimes with lower rates but no exemptions. The new system aimed to provide flexibility and reduce complexity. However, the outcome has been mixed: individuals who can avail exemptions often choose the older regime, reducing collections, while others opt for the simplified route. While efficiency and investment are the objectives, revenue buoyancy has yet to reflect these benefits.

Shifting Composition of Taxes

The structure of taxation has evolved significantly. Direct taxes—comprising income and corporate taxes—have risen steadily in share, while indirect taxes, once dominated by excise and customs and now by GST and customs, have declined. This shift reflects India’s growing formalisation and the progressive intent of the system.

Yet, direct tax buoyancy has been less robust since 2008. Income tax collections grew consistently until that point but have since flattened, underlining the need to broaden the base.

Broadening the Base

A central challenge remains the narrow tax base. Many individuals and enterprises remain outside the system. For example, agriculture continues to lie beyond the reach of direct taxation. While indirect taxes touch parts of the sector, the absence of income taxation creates a structural differentiation between agriculture and non-agriculture. Whether this differentiation is beneficial or distorting remains a live policy question.

Similarly, India’s large informal sector limits revenue potential. Many micro, small and medium enterprises (MSMEs) weigh the costs of compliance against benefits and often find the latter insufficient. Addressing this imbalance requires more than tax reform. It calls for policies that make participation in the formal economy valuable—such as access to affordable credit, market opportunities and social protections that are contingent on formalisation.

Perceptions and Compliance

Numbers alone do not tell the full story. Perceptions of fairness strongly influence compliance. In a small survey of around 100 respondents, views diverged sharply. A large cluster felt the taxes they paid were fair and that exemptions available to them provided balance. Another group believed they paid too much and preferred lower rates without exemptions. These contrasting positions highlight the complexity of designing a tax system that can satisfy divergent expectations.

When asked why tax evasion occurs, the most common response was that taxes seem high relative to the benefits citizens perceive they receive. This underscores the importance of communication. Governments must do more than collect revenues—they must also convey how those revenues are being used. Infrastructure, health, education and social welfare are funded through taxation, yet if citizens do not clearly see or understand this linkage, perceptions of unfairness persist.

Transparent communication, therefore, becomes as important as structural reform. Demonstrating the impact of revenues on everyday lives—better roads, schools, hospitals, digital infrastructure—can build trust and strengthen the social contract.

A Constructive Way Forward

India’s journey in tax reform is both a story of achievement and of opportunity. From 14 percent to 18.5 percent in tax-to-GDP ratios, from 4 percent to 7 percent in state revenues and from cascading indirect taxes to GST, progress has been tangible. Yet the tasks ahead are equally clear.

Broadening the tax base, reducing distortions, integrating the informal sector and addressing sectoral gaps like agriculture remain priorities. So too does ensuring that exemptions and concessions are aligned with efficiency rather than eroding collections. Administrative reforms—particularly those driven by technology—can further strengthen compliance and monitoring.

Above all, building trust through transparency is vital. Citizens who feel that taxes are high without corresponding benefits are less likely to comply voluntarily. Clear communication about how revenues fund public goods can correct this imbalance, encourage broader participation and ensure that growth is financed fairly and sustainably.

India’s growth aspirations are ambitious, but the foundations are solid. Constructive tax reform—focused on broadening, simplifying and communicating—offers the path to financing development while strengthening the bonds of democracy and federalism. The journey so far proves that progress is possible; the challenge now is to accelerate it.