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Taxation and the Principal-Agent problem

The principal-agent problem [PAP], in political science and economics, occurs when one person or entity (the "agent"), is able to make decisions and/or take actions on behalf of, or that impact, another person or entity: the "principal". This dilemma exists in circumstances where agents are motivated to act in their own best interests, which are contrary to those of their principals, and is an example of moral hazard.

One of the relatable cases of PAP is sales - the sales executive is likely to motivate you to buy those products where s/he earns more commissions, rather than those which are cheaper or beneficial for you. This problem occurs in any kind of a sale whether its a kitchen appliance or insurance product.

Maybe you've already guessed where I am going with this - the PAP with taxes. The government is an agent which levies a charge (taxes) on its people - possibly the strangest of principal-agent relationships [in all other cases, the agent is usually paid a fixed or pre-defined percentage of gains]. So clearly higher taxes are good for the government, but bad for people - at the same time, given that political parties depend on people's votes for staying in government, stakes are balanced. So there will be political parties who will make lower taxation a rallying election cry. So, only on the aspect of tax rates, the scale is generally balanced between the principal (people) wanting lower charges (taxes) and the agent wanting to deliver it to continue in business.

However, there is another aspect of taxation where PAP presents a particularly vexing imbalance - the complexity of the taxation system. Complex taxation usually manifests in form of increased compliance burden than just increasing tax rates. So while the rate of taxation may be low or meet people's expectations, the complexity of taxation remains high. India is a particular example of a state where every form of taxation is much more complex compared to its peers.   

  • Income tax in India not only is progressive, but there are a number of exceptions and surcharges to the tax slabs.
  • There are other forms of tax exemptions available only to entities such as HUFs (Hindu Undivided Family) only which treat a family as a tax unit rather than the individual.
  • Corporate taxes in India are currently low, but again there are several exceptions relating to CSR and other such contributions made to the society.
  • India's VAT implementation (christened GST) is one of the more complex systems with more slabs and ambiguity for goods and services which fall between the various categories defined by the law.

Apart from the complexity in applying or calculating taxes - the key aspect here is about the burden of depositing tax and compliance filings. For direct income taxes, the burden technically falls on the individual itself and for indirect taxes (GST), it is on the body-corporate undertaking the sale. However, Indian governments have successively shifted the burden of individual income taxes also on businesses / non-payers.

The first example is TDS - Tax Deducted at Source; any business which pays a salary, compensation or fees to employees, contractors or other businesses must debit taxes prior to making the payment and deposit the same with the government in name of the recipient of the monies. Similarly, TDS is also required to be debited by the buyer of a real estate property from the amount they pay to the seller, and deposit the required amount with the government and file compliance. Notably, TDS is not unique to India - other countries also have this system under names like Pay as you Earn / Go or Withholding tax.

TDS not only shifts the burden of tax compliance away from the tax-payer, but it also increases the complexity of compliance for businesses because businesses now must find out what tax slab the individual or business, to whom payment is being made, falls in; but also perform sufficient due diligence to verify the accuracy of this information before deducting taxes and depositing it with the government. 

More recently, the Indian government added a new animal to its tax compliance arsenal - Tax Collected At Source or TCS. TCS is reverse of TDS - while TDS is deducted by someone who makes the payment, TCS is 'collected' by someone who receives payment. TCS collected by a seller of goods or services from the buyer for certain kinds of purchase (ex those involving foreign remittances like booking a hotel overseas). TCS also shifts the burden of tax payment and compliance away from the actual taxpayer to another entity and the same complexities of determining tax slabs and compliance exist.

TDS and TCS are classic cases where the incentive of the agent and principal - both are divergent. While the government wants to ensure that it collects taxes from the taxpayer from all sides, but because the taxpayer itself would possibly not comply - they shift the burden to intermediaries, businesses in most cases, who have no direct relationship with the entire tax deposit/collection of the relationship.

TDS and TCS result in increased cost of operating a business in India making it less viable for smaller businesses to operate because of higher compliance costs. They also create perverse incentives on Tax authorities to harass businesses for matters which do not necessarily have a direct correlation with income and expenses of their core business. 

Ideally, better tax compliance would be achieved by digitizing the economy and incentivising people to be fair in their tax assessment. Tax compliance incentives typically would mean a simple taxation system with fewer slabs (maybe flat slab?) and no exemptions; instead of complexity. 

However, given that the tax regime in India is complex and hence prone to people evading taxes using exemptions as systemic loopholes, the government's countermeasures are in form of TCS and TDS. TDS and TCS make it difficult for people to evade taxes and may even result in collecting higher taxes, from some people, than what they actually owe. This shifts the burden away from the government to collect taxes, to citizens who now need to collect refunds. 

I must underscore and acknowledge that Taxation is a complex subject - I don't claim to be an economist or know better than civil servants running the Finance Ministry. I am not claiming that TDS/TCS are wrong, even though I do believe in the general principle that simplification always is a preferred option over over-complication in solving any problem. But rather than comment on TDS / TCS being right or wrong, the limited point I am making in this post is that by reducing 'ease of doing business', as a side effect, TDS and TCS reflect how a convoluted solution to a problem results in unexpected outcomes.

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