Cracks in the code

IT is not just a revamp, claims the government, but altogether new. After many rounds of reduction of the marginal tax rate and years of tinkering with the structure of direct taxes, it claims to have decided to alter drastically the direct tax regime. To that end it has launched a debate that would lead up to the introduction of legislation to put in place a new direct tax code. The discussion paper accompanying the draft code attempts to draw attention to a number of fea tures of the code: the definition of income, clarity regarding who can be taxed and the treatment of exemptions. But discussion on the code is likely to be dominated by the extent of taxation of personal and corporate incomes the new regime would involve.

In this regard, there is one aspect of the code that is welcome. It seeks to rationalise the innumerable exemptions given to both high-income personal income-tax payers and corporations. The consequence of this would be enhanced revenue generation and a greater degree of transparency in the tax structure. It would also possibly lead to greater equity, since most tax exemptions are either directed at or more easily exploited by those in the higher income tax brackets.

Budget documents for 2009-10 estimate that the tax expenditures on account of foregone taxes during 2008-09 amounted to Rs.68,914 crore in the case of corporate taxes, Rs.5,116 crore in the case of non-corporate (partnerships, associations of persons, bodies of individuals) tax payers and Rs.34,437 crore in the case of income taxes. This amounts to around 17 per cent of the gross tax revenues that accrued to the Central government, according to the Revised Estimates for that year. Recouping a significant share of this would make a considerable difference to the budgetary position of the government and increase its fiscal manoeuvrability.

However, if this and greater transparency and equity were the objectives that the government was pursuing, then a revamp of the existing tax law to get rid of a wide range of unnecessary exemptions would have been adequate. That the government is pursuing objectives other than these is clear from its unorthodox decision to include in the documents for discussion on the proposed Direct Tax Bill a proposal for a new structure of direct tax rates. That structure could lead to a sharp reduction of taxes currently paid by individuals and corporates in different tax brackets under the present tax regime. The way this is to be ensured is a significant widening of the tax slabs, leading to a situation where individuals would pay only 10 per cent tax as long as they remain in the slab Rs.1,60,000 to Rs.10,00,000, 20 per cent in the slab Rs.10,00,000 to Rs.25,00,000 and 30 per cent thereafter. The corporate tax rate is to be reduced from 30 per cent to 25 per cent and the minimum alternate tax (MAT) is to be calculated on the value of gross assets, 2 per cent of which will have to be paid at the minimum by all non-banking companies.

Currently, the income-tax payer pays 10 per cent tax on income between Rs.1.6 lakh and Rs.3 lakh, 20 per cent on income between Rs.3 lakh and Rs.5 lakh, and 30 per cent on income beyond Rs.5 lakh. The new proposal means that an individual who, for example, earns one lakh of rupees every month by way of taxable salary will see a substantial reduction in the amount of income tax paid. Moreover, the ceiling on tax-free acquisition of savings instruments has been increased from Rs.1 lakh to Rs.3 lakh, even though the range of instruments eligible for that concession has been reduced.

Specifying these rates and ranges, even while indicating that they are also subject to discussion, clearly ties the hands of the government. Taxes, which are increasingly seen as hurting the taxpayer and not as financing beneficial public provision, are such that once the government proposes a level it can go downwards from there but not upwards without opposition. This implies that the government has chosen to cut rates significantly by widening tax slabs and adjusting the number of rates. The governments own view is that such comparisons between the proposed direct tax regime and the existing one are not valid, because what we have is a structural transformation in regime.

One way of interpreting that statement could be that it is implicitly declaring that the potential reduction in revenues as a result of wider slabs and lower rates would be more than neutralised by the reduction in exemptions and by the increased compliance that a lighter tax regime would encourage. For example, salaries in the private sector are expected to be computed on a cost-to-company basis and the imputed rental value of rent-free accommodation (for example) is to be treated as part of the salary.

The danger here, as can be seen even in the early responses to the draft code, is that the debate in the run-up to legislative action would force the restoration of a range of exemptions while sticking with the proposed new slabs and rates. Moreover, monitoring whether the value of perquisites are actually computed and included in salary will be difficult and evasion through such exclusion can be as much or higher than in the case of evasion of post-exemption income and tax calculations. The expected quid pro quo may not materialise and revenues may, in fact, decline. Given this, the belief that the new code will contribute to an increase in tax collections is largely based on the faith that reduced tax rates will lead to better compliance. Needless to say, this faith in the Laffer curve is neither theoretically nor empirically grounded. In the event, the new tax code is ill-advised for at least two reasons. The first is that it comes at a time when, despite the consensus that public capital formation and public expenditure on social infrastructure and social protection are grossly inadequate, the deficit in the Union Budget is rising. Even though there are expectations that the deceleration in growth in India, induced by the global crisis, is hitting bottom, there is substantial agreement that the government must keep expenditure high if the rate of growth is not to slump further.

This would lead to inflation if it is financed by borrowing rather than by a draft on private savings through taxation, given the fact that food-price inflation is already high and a truant monsoon is likely to intensify supply constraints. This, then, is the least propitious time to launch an adventurous experiment in resource mobilisation involving a cut in direct tax rates.

But the case against the code is not just short term. It would also abort the much-needed correction of the decline and stagnation of the tax-GDP (gross domestic product) ratio at the Centre.

One striking feature of the 1990s, which was the first decade of accelerated economic reform, was that despite evidence of reasonably good growth rates and signs of growing inequality, there was no improvement in the Centres ability to garner a larger share of resources to finance expenditures it considered crucial. Even when corporate profits and managerial salaries were reported to be rising sharply, taxes did not appear as buoyant. The Central tax-GDP ratios in India were declining for much of this period. And despite the increase in the ratio in recent years, only in 2006-07 it exceeded its 1989-90 level (see chart). Despite high growth, improved profitability and signs of increased inequality (which should improve tax collection), the increase has been adequate to just about put the tax-GDP ratio back to its immediate pre-liberalisation level. Thus, an effort to raise this ratio even further is what is called for.

If these imperatives have been ignored in the new code it must be because of the view that households taxed lightly will increase their consumption and firms taxed lightly will invest more, and the enhanced consumption and investment will drive growth. There are three problems with this argument. First, it underestimates the role of public expenditure in general and public capital formation in particular in crowding in on private investment, as amply illustrated by past Indian experience.

Second, it privileges GDP growth even at the cost of reducing the role of direct taxation in moderating the inequalising character of recent economic growth. Finally, it completely ignores the important role of tax-financed public expenditure in alleviating poverty, providing social protection and advancing human development.

The tax code is a signal that UPA-II plans to continue with the policy of cajoling private capital into investing for growth with concessions that have adverse equity and welfare implications.