There comes a point in time when citizens voluntarily opt to formalise their business - recognising that the benefits they will receive are worth the downside of coming within the tax net. Countries can leverage this notion to unlock much needed revenue by following a three-step process.

This is a link-enhanced version of an article that first appeared in the Mint. You can read the original here.

Despite all that has been said about the success of India’s digital transformation, questions are still being asked as to whether the digital public infrastructure (DPI) we are so proud of actually reaches those who really need it. And, if it does, whether the intended beneficiaries are actually using it.

Take the undeniably impressive growth in bank accounts opened across the country. Doubts have still been expressed over whether these accounts are actually being used by those who need them or whether the exponential growth in India’s digital payment ecosystem has been powered by the top 15% of Indians—the 200 million or so who, even before the proliferation of India’s DPI, controlled over half the spending power of the economy and almost all its discretionary spending.

Much of this scepticism comes from our own lived experiences. We have known for a while that a large chunk of our economy operates in cash, and that most small businesses we interact with would prefer to conceal their total income because they know that becoming taxpayers simply increases their liability without offering them any material benefits. This is why businesses in India have remained small and informal for the most part.

Things Are Changing

But things have begun to change. Today, there are over 14 million businesses registered on the goods and services tax (GST) platform, 70% of which are small and medium-sized enterprises (SMEs). As a result, GST revenue has grown by over 50 basis points as a proportion of gross domestic product (GDP) since 2018. There has also been an 80% increase in income-tax returns filed, from 38 million in 2013-14 to 69 million in 2020-21. All this has meant that gross tax collections have grown over 4 times from 2009-10 to now, outpacing the 3.6 times growth in GDP during the same period.

This is what Nandan Nilekani referred to in a presentation that spread virally on social media last year, tracking India’s steady upgrade from an offline, cash-based, informal and low-productivity economy to an online, cashless, formal and high-productivity one. This, he argued, is evidence that more and more Indians are making a Grand Bargain: voluntarily formalizing their businesses because of the benefits they can see accruing to them as a result.

In a recent article in the International Monetary Fund’s Finance and Development magazine, Kamya Chandra, Tanushka Vaid and Pramod Varma suggest that countries around the world can learn from India’s experience. With global debt projected to reach 100% of GDP by the end of the decade, countries will simply not be able to borrow the $3 trillion or so they have to spend every year if they are to have any hope of addressing their development and climate transition needs. But most of these countries also have an untapped tax potential of 8–9% of GDP, and if they can increase their revenue from taxation, they will have an alternate source of funds that could be used to meet these requirements.

Three-Step Path

To do this, the authors argue, countries should follow a three-step path. First, they need to reduce entry barriers to the formal financial system to a point where the effort of participating is no longer the daunting obstacle that it currently is. For instance, if they can enable the use of digitally verifiable assets, credentials and systems—business identification numbers, digitally signed licences and permits and fast payment systems—small businesses will find it far less cumbersome to enter the formal economy and participate than they currently do.

The next step would be to align incentives properly so that small businesses can realize for themselves that it is far more valuable for them to operate within the formal economy than outside it. If, for instance, it is possible for them to use the digital trails they have laid down over a significant period of time as verifiable proof of the cash flows of their business, they should be able to use this as evidence of their credit-worthiness, allowing them to access formal credit at competitive rates.

While the first two steps will allow businesses to appreciate the benefits of joining the formal system, it is also important to provide them with incentives to go formal through the tax system. In India, the tax department offered businesses income-tax credit rebates of up to 20% if they purchased goods and services from suppliers that had registered and were paying tax. This incentivized businesses up and down the supply chain to get registered.

In addition, taxpayers were given access to their data in a format that they could use. By offering them digitally-signed identification, taxpayers could use their tax credentials for electronic Know-Your-Customer verification. By allowing core business registration information to be digitally verified, businesses were also able to reliably build trust in the commercial ecosystem.

On their Own...

While this three-step process will lead to greater and more transparent tax collection, the IMF paper’s authors are at pains to point out that this should under all circumstances be the secondary and not the primary objective of the exercise. It is crucial that citizens decide on their own to submit themselves to the tax system—having decided that it is in their net interest to do so.

They will probably accept the Grand Bargain only once they understand for themselves that the benefits of participating in the formal economy far outweigh any gains of not doing so.