What is tax buoyancy, how it works for the government?

There is a strong connection between the government’s tax revenue earnings and economic growth. The simple fact is that as the economy achieves faster growth, the tax revenue of the government also goes up.

Tax buoyancy explains this relationship between the changes in government’s tax revenue growth and the changes in GDP. It refers to the responsiveness of tax revenue growth to changes in GDP. When a tax is buoyant, its revenue increases without increasing the tax rate.

How tax buoyancy works?

A simple example in the context of our economy indicates the power of this concept. In 2007-08, everything was fine for the economy. GDP growth rate was nearly 9 per cent.

Tax revenue of the government, especially, that of direct taxes registered a growth rate of 45 per cent in 2007-08. We can say that the tax buoyancy was five (45/9).

Now in the next year, in the wake of the global financial crisis impact, GDP growth came down to six percent. Tax revenue growth also fell steeply; to 18 per cent. This means tax buoyancy was 3 for the year. We can imagine that had the GDP growth came down further in the next year, to say 4 per cent, tax revenue growth would have fell to 8 per cent; indicating a tax buoyancy of 2.

Hence, tax buoyancy shows the association between economy’s performance and the government’s ‘happiness’ (tax revenue). it indicates the high sensitiveness of tax revenue realisation to GDP growth.

This concept reveals some interesting aspects as well as some interesting questions. First thing is that the government can feel relieved and happy if the economy achieves higher growth. It may not borrow highly to finance the budget. New schemes and programmes can be lavished because of high revenue growth. In 2007-08, the then FM, P Chidambaram could not hide his joy by declaring that he is the happiest of all FMs. Understandably, the biggest beneficiary of a higher GDP growth rate is the government itself. 

Second is that tax buoyancy will be highest for direct taxes. As the economy grows fast, the additional income generated may go to the rich group. A part of that they have to pay to the government in the form of taxes. So if the GDP growth rate registers high say, nine percent, direct income tax collection will accelerate. Generally, direct taxes are more sensitive to GDP growth rate.

What is tax elasticity?

A similar looking concept is tax elasticity. It refers to changes in tax revenue in response to changes in tax rate. For example, how tax revenue changes if the government reduces corporate income tax from 30 per cent to 25 per cent indicate tax elasticity.

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