What is Tax Buoyancy: Meaning, Formula, Calculation, Example

It is an enormous challenge for every government across countries to finance public expenditure without disturbing economic growth. Taxation is surely the most sought after route, but planning and adopting an appropriate tax policy can be an uphill task. In this article, we discuss the concept of tax buoyancy, its meaning, formula with examples, as a measure of efficacy of a taxation policy for public finance.  

What is tax buoyancy?

Tax buoyancy is a ratio of change in tax revenue in relation to change in gross domestic product or GDP of an economy. It measures how responsive a taxation policy is to growth in economic activities. 

Example: 

• A taxation policy with a tax buoyancy of over 1 will deliver more tax revenue following a positive change in gross domestic product. 
• Lower the tax buoyancy poorer is the tax collection in response to economic growth. 
• The Central Government of India estimates a tax buoyancy of 1.1 for 2024-25 financial year. 

Credit: Indian Express 

Importance or significance of tax buoyancy

As a measure of the efficacy of a taxation policy, tax buoyancy is important for several reasons.  

• It shows an economy’s capacity to finance growing public expenditure with tax revenue. Policy makers use the tax buoyancy ratio as a measure of their taxation policy’s reliability to deliver a steady flow of tax revenue. Every developing economy requires buoyant taxation policy to reduce dependency on costly debts for financing government expenditure. 
• Buoyancy of tax policy helps to overcome economic exigencies. A government can finance its expenditure using tax revenue, income from government-owned enterprises, disinvestment proceeds, and debts. A highly buoyant tax policy can help a government rely on tax collection despite sudden fluctuations in earnings from other sources. For example, the planned direct tax buoyancy of India for FY25 is around 1.1. This will help the government meet expenditure even if its disinvestment targets are not met. 
• Tax buoyancy as an indicator helps policymakers in designing pro-taxpayer taxation policy. Tax revenue is essential to sustain government expenditure. But higher tax rates can also negatively affect willingness to pay tax and increase tax evasion. Besides, a high rate of tax disrupts economic growth. Policymakers can use the tax buoyancy indicator to increase tax collection without increasing tax rates. 

Tax buoyancy formula

The simplest way to calculate the tax buoyancy of a taxation system is: 

Formula of tax buoyancy = [Percentage change in tax collection] / [Percentage change in the economy’s GDP]

For example, let us assume, 

• Tax revenue for a particular period grows by 5%. 
• For the same period, the GDP of the economy grew by 4%. 
• Using the formula, tax buoyancy of the existing policy will be 1.25. 

It indicates that the existing taxation system can be termed buoyant.

Policymakers can estimate tax buoyancy using a regression analysis based on a time series statistical model. Following this approach, statisticians establish a relationship between ‘collected tax revenue’ and ‘economic activities’ as a tax base. The elasticity coefficient of the dependent variable can provide a fair estimate of tax buoyancy.

For example, a reference equation for regression analysis:

log T = α0 + α1 log B + ϵ

In this equation: 

• T = time series data on tax collection 
• B = time series data on economic activity or tax base 
• α1 = estimation of tax buoyancy 

How to calculate tax buoyancy? 

The steps to calculate or estimate tax buoyancy are: 

1. Collect multi-year time series data on tax collection 
2. Collect data on variables representing the tax base or economic activity over the same period under consideration. Examples of such variables can be GDP, personal income, corporate profits, consumption, etc. 
3. Plot a regression model based on the data collected using the tax revenue as a dependent variable and the tax base as a combination of independent variables.
4. The coefficient of the set of independent variables is the estimated tax buoyancy.

Tax buoyancy examples

• The GST has improved the tax buoyancy of the indirect taxation system in India to 1.22 from the pre-GST tax buoyancy of 0.72. It shows GST is reliable for a steady flow of tax revenue following an increase in sales turnover. 
• During 1999-2000, tax buoyancy of direct taxation policy was weak, causing poor tax revenue. It increased during 2003-04 following tax reforms.

Factors affecting tax buoyancy

Tax buoyancy of a tax system depends on many factors. 

• Size of tax base: It directly impacts tax collection and thus affects tax buoyancy. For example, the inability to increase the number of taxpayers in an economy can lower tax buoyancy despite an increase in tax rate. 
• Taxation structure: Taxes based on consumption expenditure are regressive. Such tax policies can impact tax buoyancy. On the other hand, taxation on income and profit are progressive and thus good for higher tax buoyancy. 
• Administrative efficiency: Efficacy of a tax policy critically depends on tax administration. Poorly managed and inefficient administration reduces the risk of getting punished following tax evasion. It promotes tax avoidance. So, the better the tax administration, the higher the tax buoyancy is.  
• Tax rates and exemptions: It has been observed that higher tax rates can reduce tax buoyancy as it disrupts economic activities. Similarly, an increase in tax rebates, exemptions and tax deductions can improve tax buoyancy. However, the extent of these factors can be a matter of debate.  

Challenges in achieving high tax buoyancy

Some of the practical challenges to achieve high tax buoyancy are: 

• Economic exigencies and volatility - Sudden disruption in economic activities like natural calamities, global pandemic can derail any estimation of tax buoyancy. 
• Increasing tendency of tax avoidance - Despite the best efforts in designing a highly buoyant tax system, the general tendency to evade tax in an economy reduces tax buoyancy. 
• Lack of political motivation - Efficiency of tax administration sometimes depends on the political willingness to enforce strict anti-evasion laws. Lack of political motivation to punish tax avoidance and evasion reduces buoyancy.
• Narrowing taxable base - Reduction in the tax base affects tax buoyancy negatively.