Previous Year Question
A decrease in the tax-to-GDP ratio of a country indicates which of the following?
Slowing economic growth rate
Less equitable distribution of national income
Select the correct answer using the code given below:
1 only
2 only
Both 1 and 2
Neither 1 nor 2
Correct Answer: A
Detailed Solution
The Tax-to-GDP Ratio measures the tax revenue collected by the government relative to the size of the economy.
It shows how much tax the government collects out of every ₹100 of economic output generated in the country.
Statement 1 is correct. When economic growth slows, growth in income, profits, production, sales and consumption may also weaken. Consequently, collections from income tax, corporate tax, GST and other taxes may not increase at the expected rate. If tax revenue grows more slowly than GDP, the Tax-to-GDP Ratio may decline.
For example, if Nominal GDP increases by 10% but tax revenue increases by only 5%, the Tax-to-GDP Ratio will fall.
An important qualification is that a decline in the Tax-to-GDP Ratio is not caused only by an economic slowdown. Lower tax rates, tax exemptions, weak tax compliance, a large informal sector or poor efficiency of tax collection can also reduce it. Nevertheless, among the alternatives given in the question, slowing economic growth is an appropriate indication.
Statement 2 is incorrect. A decline in the Tax-to-GDP Ratio does not automatically establish that the distribution of national income has become less equitable. Income distribution and inequality are assessed through indicators such as income shares of different groups, the Gini coefficient, consumption distribution and wealth distribution.
A tax system can affect income distribution, but its effect depends upon:
Whether the tax structure is progressive or regressive;
The relative shares of direct and indirect taxes;
The groups and programmes on which the government spends tax revenue;
The distribution of social transfers and subsidies.
Therefore, two countries with the same Tax-to-GDP Ratio can have entirely different patterns of income distribution. A decline in the ratio alone is not conclusive evidence of a less equitable distribution of national income.
The Tax-to-GDP Ratio is also important because higher and stable tax revenue provides the government with greater Fiscal Space for health, education, infrastructure, social protection and capital expenditure.