Tax Buoyancy: Too Noisy for Signals

The true trend in tax revenues has been obscured by pandemic-related effects, inflation, and discretionary policy changes, which hinder accurate economic assessments for several successive years.

What can we conclude about the post-pandemic recovery based on tax revenues? How much information can we derive from the observed tax buoyancy? What does it tell us about the strength of revenue growth, fiscal sustainability, and the economy’s structural features? Such questions are relevant from the standpoint of recovery from the pandemic, the resurgence of inflation, and tax policy responses in the just-concluded financial year. Given these exceptional developments, the historical relationship of tax revenues with GDP is unlikely to have remained unchanged; rather, more probably, this might have been disturbed. This note attempts to unravel these critical issues.

Tax buoyancy, a measure of how tax revenues move with changes in output,[1] reflects the underlying attributes of an economy, effective collections, and the effects of policy measures implemented over a period. In a downturn, the metric can guide the fiscal actions needed to provide demand support in case transfers or welfare expenditures were not budgeted ex-ante. Macroeconomic signals from movements in this ratio are invaluable as they inform us about the evolution of fiscal balances. A value of one, for example, would imply no change in the tax–GDP ratio, and, therefore, indicates fiscal sustainability. A value less than unity would mean a larger fiscal deficit and the consequent need for offsetting discretionary measures. A score exceeding one would reduce the deficit ratio because greater growth will raise revenues faster than the GDP. It is also the key metric that provides the revenue outlook that authorities use for their budgetary forecasts and planning. Most importantly, the automatic movement of tax revenues along with the GDP provides information on the economy’s health—the two series are highly integrated due to a long-term relationship with profits, incomes, sales, etc.—the proxy bases.

Historical relationships can, however, be disturbed by exceptional shocks that usually induce governments to change tax policy in response, called ‘additional revenue measures’ or ARMs. Such policy measures make accurate assessments difficult. Tax policies have been a particularly critical tool in many countries’ fiscal response to COVID-19. A better and more precise measure is tax elasticity, which is net of policy changes. However, this calculation requires knowledge and quantification of tax policy adjustments, about which information is mostly unavailable or incomplete.

This note discusses three significant reasons why the observed tax buoyancy in the recovery year,
FY23, must be interpreted with caution. The coincidence of unique demand and supply conditions
owing to pandemic recovery, sustained and high inflation for two years, and numerous special
measures on the revenue side make it difficult to discern the underlying signals from the observed
tax buoyancy.