When one needs to assess how well a country’s government uses its economic resources through taxes, one of the key metrics used is the tax to GDP ratio. As the name suggests, this ratio is used to compare how much tax revenue a government collects relative to the country’s overall economic output, that is, the gross domestic product. Here we’ll discuss why the tax to GDP ratio matters, what factors influence it, and how it affects the economy.
What is Tax to GDP Ratio in India?
The tax to GDP ratio is a metric that is used to compare a nation’s tax revenue to the size of its economy. This ratio is used to gain insights into the efficiency and effectiveness of a government’s total tax collection relative to its economic output. Before we go any deeper into the tax to gdp ratio meaning, let’s first understand what exactly total tax revenue and GDP mean.
Total Tax Revenue
This refers to the combined tax collected by the government from all sources over a specific period. It includes both indirect taxes (such as GST and excise duty), as well as direct taxes (like income tax).
Gross Domestic Product
GDP is one of the most important metrics that is used to assess the size and the health of a nation’s economy. By definition, it is the total worth of all the finished goods and services produced within a country over a specific period.
Here’s how the tax to GDP is calculated:
Tax to GDP = (Total tax revenue of a nation over a given period / The nation’s GDP) * 100
Generally, the total tax revenue is used to calculate the tax to GDP ratio. Still, the formula can be modified to reflect only the revenue earned from direct or indirect taxes. The higher the tax to GDP ratio is, the more taxes a country is collecting compared to its total output, and thus the greater its ability to fund education, health, infrastructure, defence, and other important expenses. On the other hand, a lower tax to GDP ratio indicates that the country is not effectively generating enough revenue to meet its expenditure needs, which results in budget cuts, more loans, and reduced government spending on many basic public services.
Developed nations tend to have higher tax to GDP ratios compared to developing nations. According to the World Bank, a tax to GDP ratio of more than 15% is considered enough to ensure a country’s economic growth in the long run. For reference, the tax to GDP ratio india had in the year 2022 was over 18% according to the International Monetary Fund.
Example of Tax to GDP Ratio
Let’s take a simple example to see how the tax to GDP ratio is calculated. Suppose in a given year, the total tax revenue of country A was Rs. 5 lakh crores and its GDP was Rs. 25 lakh crores. Country B collected Rs. 2 lakh crores in tax revenue while having a GDP of Rs. 20 lakh crores.
1. Tax to GDP ratio for Country A:
(Rs. 5 lakh crores / Rs. 25 lakh crores) * 100
Tax to GDP Ratio (For A) = (1/5) * 100
Tax to GDP Ratio (For A) = 20%
2. Tax to GDP ratio for Country B:
(Rs. 2 lakh crores / Rs. 20 lakh crores) * 100
Tax to GDP Ratio (For B) = (1/10) * 100
Tax to GDP Ratio (For B) = 10%
Since Country A has a higher tax to GDP ratio than Country B, it means that Country A is more efficient and has a broader revenue base to support public expenditure.
Why is Tax to GDP Ratio Important?
For any government, taxes are resources needed for funding public services like education and healthcare, infrastructure, defence, and social welfare programs. Governments monitor the tax to GDP ratio as it is a reliable indicator of the taxes they earn compared to their country’s economic output. More taxes mean a higher ratio, which ultimately helps the government fund their programmes. As the tax to GDP ratio grows, governments become less reliant on other sources of funding, such as borrowing, and also attract new investors as a growing ratio indicates economic stability.
The World Bank suggests a tax to GDP ratio of 15% or higher is an indicator of sustainable growth and fiscal stability. It helps the government fight poverty and improve the standard of living for its citizens. Governments and policymakers also frequently use this ratio to understand how well their current tax policies are working and what changes can be made to improve tax collection.
Since the tax systems between different countries can differ significantly, the tax to GDP ratio can also be used as a tool to compare the efficiency of tax collection and the fiscal capacity of governments to a certain extent.
Factors Affecting the Tax-to-GDP Ratio
The following factors have an impact on the tax to GDP ratio:
1. The GDP
When the GDP rises, the tax collections tend to increase as well. This is because a growing economy leads to more economic activity – higher incomes, consumption, and business activities, all of which contribute to higher tax revenue. As a result, the tax to GDP ratio rises.
2. Economic Policies
Economic policies, especially those that have a direct impact on tax such as new tax slabs, deductions, exemptions, benefits, and changes to GST rates play a huge role in determining tax collection. Tax policies can also help influence investors to participate in the markets.
3. Tax Compliance
Illegal and unethical practices such as tax evasion and avoidance can reduce the amount of tax collected. Poor tax administration can also lower the total tax revenue. For example, the informal sector in our country especially isn’t well regulated, which makes it hard for the government to accurately track and collect taxes from a significant portion of economic activities.
Tax to GDP Ratio Trends in India
Over the last decade, India has seen a steady rise in GDP, tax collected, and consequently, the tax to GDP ratio. If we were to talk about only the direct tax, the tax to GDP ratio India as reported by the government increased from 5.62% in FY 2013/14 to 6.11% in FY 2022/23. By FY 2024/25, this ratio is expected to grow to 6.7%. As far as indirect taxes go, the progress is comparatively slower.
The steady growth of the tax to GDP ratio signifies that the tax revenue collected by the government rises at a higher rate than the country’s GDP. As the nation develops and the per capita income increases, the tax to GDP ratio will continue to grow.
Impact of Tax to GDP Ratio on Economic Growth
A higher tax to GDP ratio allows the government to build infrastructure like railways, roads, and airports, and also to invest in public services like healthcare, education, and public transport. It also helps the government lower fiscal deficits as more tax collection means the government is less reliant on loans. High tax to GDP ratios indicate stability, which attracts investors and creates ease of doing business.
A key function of the government is to reduce poverty and elevate the position of people below the poverty line for their well-being and contribution towards the nation’s development. The progressive income tax system helps the government redistribute some income through welfare programmes.
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Conclusion
The tax to GDP ratio is a financial metric that compares a country’s total tax collected to the size of its economy. For example, a 25% tax to GDP ratio would imply that for every Rs. 100 worth of goods and services India produces, the government is collecting Rs. 25 in taxes. Developed countries have higher ratios compared to developing nations, which means they collect more tax revenue relative to their economic output.
Consequently, they are able to invest more in projects related to public services, infrastructure, social welfare, and defence, improve the quality of life of their citizens, and be less reliant on borrowing. The World Bank considers a tax to GDP ratio of 15% to be a minimum benchmark for a country’s financial health, as it indicates the country is collecting enough revenue to fund the essential services required by the citizens and support its economic growth in the long term.
