Key direct taxation proposals in the July 5 budget triggered a sharp precipitation in business and market sentiment. On Friday, finance minister Nirmala Sitharaman reversed some of those mood-spoilers and indicated the residual irritants could also be dropped soon. Going forward, more tax reforms can be expected, with the submission of a key report earlier this week to GoI marking a step forward in the process to bring in anew income-tax legislation.
To what extent this long-awaited reform can be growth-enhancing will depend on the design and philosophy of the new tax system proposed. India deserves a tax law that is easy to comply with and difficult to evade or avoid. Besides revenue considerations, the link between taxation philosophy and economic growth is crucial in the current context of an unfolding economic slowdown.
The Income Tax Act, 1961, that has had more than 2,000 amendments, is incomprehensible and, in many places, even contradictory. Increasingly, the clear position of law is no longer discernible to taxpayers, tax administrators, practitioners or judges. This leads to avoidable waste of national time and economic resources, and growing scope for rentseeking by the taxman.
On two significant counts, India’s taxation philosophy has regressed to the pre-1991 era — the rates structure, and the inherent bias in the tax treatment of equity versus debt. In 1946-47, the maximum marginal rate of tax on personal incomes was 96.88%. It was brought down to 85% by 1971-72. The period was characterised by unimpressive growth in tax revenue and GDP. This was changed when the ‘Dream Budget’ of 1997-1998 slashed the maximum marginal rate to 30%. As a consequence, direct tax collections that had been 1.25% of GDP in 1950-51 rose to 3.04% in 2001-02. They further increased to 6.12% by 2007-08 and slightly lower, at 5.84%, in 2017-18.
The number of tax papers that had crept up from 0.2% of the population in 1960-61 to barely 1.14% by 1994-95, increased to 2.72% in 2003-04 and 4.97% by 2015-16. The corporate tax rate in India was among the highest across 171 countries in 2018. High rates encourage firms to push profits overseas to low-tax jurisdictions.
The July 5 budget hiked the maximum marginal rate to 42.7%, to an extent reversing the reform accomplished in the 1990s. On Friday, Sitharaman indicated a reversal of this can be expected. Reverting to the philosophy of aiming for higher compliance rates and lower evasion throungh lower rates is a good move. Then, there is inherent bias in the Act against equity and in favour of debt. The bias does seem to explain why companies have tended to finance investments by raising loans more often than by equity.
The task force report submitted on Monday has not been made public yet. But the two key reforms needed in the taxation approach were, in fact, highlighted in an earlier version submitted in August 2018. Its recommendations flowed from an understanding of the Act’s flawed philosophy. It argued that interest on debt is deductible in determining profit while dividend payout is not. So, the marginal effective tax rate (METR) on equity financing is relatively high at 52.24% — assuming all post-tax corporate profit is distributed as dividend, and includes the 10% tax on dividends received in excess of Rs 1 million. METR on debt is just 30.9%, a clear incentive for higher leveraging to reduce the weighted average cost of capital, the report said.
Removing the bias can lead to better allocation of resources for building capital, and end the private investments slowdown. Treating equity and debt alike can reduce the corporate sector’s tax-induced dependence on credit over-leverage, which every few years escalates into an NPA crisis in public sector banks. The recommendations, therefore, were a tax rate of 15% for personal incomes between Rs 6 lakh and Rs 20 lakh, and 30% for incomes exceeding that. It suggested a corporate tax rate of 5% for banks, financial institutions including NBFCs, and power-producing companies and 15% for all other companies. Plus, to ensure zero loss in revenue collections, discontinuation of all existing incentives, exemptions and minimum alternate tax.
Except for contributions of up to 10% of gross income to the National Pension Scheme (NPS), all other deductions and exemptions were proposed to be withdrawn. Surcharges were proposed to be retained, and for corporates levied at a uniform rate of 10%. Removing exemptions will not only preserve revenue collections, but also eliminate the bias in favour of debt and help revive investments.
This government has a historic opportunity to rewrite the tax philosophy and design a law relevant for the next 50 years. It will be a pity if the two flaws make it to the new legislation as well.