Money for a good purpose

Print edition : August 11, 2006

The government cannot claim that it has no money for poverty alleviation programmes when clearly it has failed to tax the rich adequately.

CONFRONTED with demands for increased expenditure on programmes to alleviate poverty and address the worst forms of human deprivation, the common refrain of the government has been: "Where will the money come from?" Implicit in that rhetorical question, which is not looking for an answer, is the idea that surplus resources in the system available for allocation to such expenditures are limited. The perception is that if the government seeks to tax away a larger part of available surpluses to finance social expenditures, it would be creating disincentives for private investment and adversely affecting growth. If it does not resort to such taxes and yet undertakes such expenditures, the deficit on its budget would widen to an unsustainable degree.

The idea that surpluses are limited challenges what was for long considered sound economic judgment. In the 1950s and 1960s, economists concerned with development had concluded that national savings and government revenues in most developing countries were as low as they were, not because these countries were poor but because their governments had failed to tax adequately the rich. This meant that tax revenues of the government were lower than warranted. Further, since these richer sections allocated a significant share of their incomes to consumption that would be considered non-essential at the levels of average income recorded in these countries, savings rates were also below their potential.

There is no reason to believe that this is untrue in India today. In fact, those who accept the government's arguments on resource constraints must be convinced that economics is too complex to be understood. This is because a casual observation of the lifestyles of the well-to-do in metropolitan India and the burgeoning of conspicuous consumption in various forms would suggest that the system is flush with surplus money. If yet the official view is that the government's hands are tied because of a lack of money, it must be that the issue is more complex than it actually seems.

In reality it is not. The fact of the matter is that despite the government's efforts to widen the tax net and improve tax collection, the tax-gross domestic product (GDP) ratio in India is still low by international standards, including those of many developing countries. What is more, even when corporate profits and managerial salaries are rising sharply, taxes do not appear as buoyant. An important reason for this is that while inequality increases, marginal tax rates have come down sharply during the liberalisation years.

In 1985-86, the marginal rate of taxes on personal income was brought down from 62 per cent to 50 per cent and the corporate tax rate from around 60 per cent to 50 per cent. In the Budgets of the early 1990s, especially those of 1992-93 and 1994-95, the marginal rates were further reduced to 40 per cent. Today, they stand at around 33 per cent.

Along with this decline, there have been specific tax give-aways that have eroded revenues, especially in areas where returns in recent years have been substantial. A striking example is the income earned from equity investment. There are two principal ways in which income is garnered through such investment: dividends and capital gains. Both categories have benefited from recent tax concessions. To start with, in 1999-2000, dividends paid out to shareholders were made tax free, on the grounds that corporate taxes are already taxed and that taxing the shareholder's dividend income would amount to a form of double taxation. Being controversial, this decision was reversed in the Budget for 2002-03, only to be reinstated in the Budget for 2003-04.

What is the fallout of this exemption? An extremely revealing analysis by B.G. Shirsat (Business Standard, July 14 and 22/23) of 1,050 major dividend-paying, listed companies has found that dividends paid out during the three years ending 2005-06 amounted to Rs.29,532 crores. Since the beneficiaries of these dividends are likely to be in the highest marginal tax bracket, the government would have earned an additional Rs.10,000 crores by taking the dividend over these three years (if we assume that the dividend payout rate would have been the same even if the tax was effective). This is by no means a small sum.

What is noteworthy is the inequality in the distribution of this tax benefit. It is known that a minuscule proportion of the domestic population invests in equity. But even among them, the distribution of dividend and therefore the benefit of the tax exemption is highly skewed. Of the close to Rs.30,000 crores of dividends paid out by these companies, Rs.14,000 crores or around 45 per cent accrued to the promoters of the companies themselves.

In fact, small or so-called "retail" shareholders received a relatively small share of this benefit. Over 90 per cent of the shareholders holding up to 500 shares each received just over Rs.4,000 crores of dividend income, while public shareholders with equity holding in excess of 500 shares garnered Rs.7,575 crores as dividends. A significant amount of the dividend paid to public shareholders went to foreign investors. Foreign institutional investors (FIIs) received Rs.12,808 crores of dividend income during this period and investors in global depositary receipts (GDRs) and American depositary receipts (ADRs), non-resident Indian (NRI) investors and other overseas bodies received Rs.4,567 crores. In sum, a combination of promoters, high net-worth domestic investors and foreigners were the main beneficiaries of the dividend tax hand out. There remains the argument that the exemption of dividends from taxes was not a hand out but the redress of an unjust scheme of double taxation. Even if this is accepted, there remains the fact that there is a high degree of inequality in the distribution of incomes in the country, which the accrual of record dividend incomes seems to aggravate substantially. If the idea was for the government to garner a fair share of the surplus for social and capital expenditures, then the removal of the tax on dividends should have been accompanied by an increase in the marginal corporate tax rate. The fact that the government has not chosen to resort to such an increase only strengthens the perception that it has failed to tax a section of the rich adequately and effectively.

Additionally, if we take into account the fact that the expansion of corporate revenues and profits has not been accompanied by an expansion in employment that can make a difference to the backlog of unemployment and underemployment in the country, then the need for the government to garner surpluses to finance employment promoting schemes is obvious. Its failure to garner a share of the surpluses is a failure to ensure broadbased development.

The evidence on unwarranted benefits to investors in equity does not end here. It is visible in the case of the other form of return from equity holding - capital gains - as well. As has been noted before in these columns, the Budget for 2003-04 also decided that, "in order to give a further fillip to the capital markets", all listed equities that were acquired on or after March 1, 2003, and sold after the lapse of a year, or more, were to be exempted from the incidence of capital gains tax.

Capital gains made on those assets held by the purchaser for at least 365 days were defined for taxation purposes as long-term gains. Long-term capital gains tax was being levied at the rate of 10 per cent up to that point of time.

An analysis of share price movements of 28 Sensex companies found that if we assume that all shares purchased in 2004 were sold after 365 days in 2005, the total capital gains that could have been garnered in 2005 would have amounted to Rs.78,569 crores. If these gains had been taxed at the rate of 10 per cent prevalent earlier, the revenue yielded would have amounted to Rs.7,857 crores. That reflects the revenue foregone by the state and the benefit accruing to the buyers of these shares.

It is indeed true that not all shares of these companies bought in 2004 would have been sold a year-and-one-day later. But some shares which were purchased prior to 2004 would have been sold during 2005, presumably with a bigger margin of gain. And this estimate relates to just 28 companies.

In sum, the stock market alone has become the site for tax-exempt gains of a magnitude that suggests that a more appropriate tax policy relating to dividends and capital gains could have yielded substantial revenues for the government. This is only one area. There are many more such revenue sources that the government should look to when looking for money to finance crucial expenditures. There is enough money to tap from sources that should be tapped. And there are far too many good purposes that such money can serve.

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