Financial Daily from THE HINDU group of publications
Monday, Dec 30, 2002
Kelkar panel explains logic of its proposals
Presenting the final report on tax reforms, Dr Vijay Kelkar.
THE Consultation Paper of the Task Force on Direct Taxes was made available on the Web site of the Ministry of Finance and Company Affairs, inviting comments and suggestions of all concerned. A panel has attempted to distill the major themes that emerged from the reactions to the consultation paper.
Excerpts from the `Response of the Task Force':
Approach for reformulation
One of the most perceptive reactions received by the Task Force is that while appreciating the thrust of our tax reforms proposals, the advice is that it must have a human face. In other words, it must especially address the concerns of the vulnerable sections such as senior citizens. It was felt that the Consultation Paper was not sufficiently sensitive to the problems and requirements (such as housing and old age income security) of senior citizens and low-income groups. The Task Force accepts this thoughtful advice.
Hence, in reformulating our proposals, while maintaining their essential thrust and approach, we have accepted the principle that no vulnerable class of taxpayer shall be worse off because of our proposals. Keeping this principle in view, the Task Force has modified its consultation paper proposals so as to, inter alia,
Benefits for salaried and non-salaried tax-payers
A major underlying theme in the comments received was that the Task Force proposals are pro-corporate sector rather than pro-individual tax-payers. Fortunately, this perception is easy to rebut since it could not be further from the truth.
With the proposed personal tax rates, disposable income will be higher for every class of taxpayer. This also means that the entire middle class will benefit from our proposals. It is estimated that the personal tax burden for the existing taxpayers will be reduced by as much as Rs 7,900 crore per annum.
The proposed tax reforms leave the choice of deploying a taxpayer's income to the individual. In other words, the choice regarding how much to save and in which asset is left to the individual rather than being directed by the tax code. Effectively, by moving away from a paternalistic tax system, the Task Force has sought to empower the individual taxpayer.
The Task Force received a very large number of comments with regard to our proposal for withdrawal of tax exemptions on interest payment on loans for self-occupied houses. The Task Force accepts the view that the housing sector is one of the key sectors of the Indian economy in terms of providing growth and employment and it is indeed a leading sector. However, our proposal was based essentially on the consideration of horizontal equity (equity between sectors) and vertical equity (equity among various income groups).
The extant treatment also generates a tax distortion in the investments of a household among different classes of assets. For instance, a family that invests in the professional education of its children is putting resources into building human capital which can cost as much as many a small dwelling. This investment in human capital does not get tax benefits, while buying a house and living in it does. In other words, if a family wants to send a daughter/son to a medical, engineering or other professional college which can be an investment of around Rs 5-6 lakhs, this investment gets no tax benefit, unlike the tax benefit given for owner-occupied houses. This violates horizontal equity.
It is for these reasons that the Task Force had initially recommended the elimination of this tax benefit. However, we have received almost universal reaction that this facility should not be eliminated for a number of reasons. In order to protect low-income groups, we suggest an interest subsidy of 2 per cent for housing loans up to Rs 5,00,000 to all borrowers. This will help prospective homebuilders whose income is less than Rs 1 lakh. Until such time this proposal is adopted, we also recommend the continuation of interest deduction of up to Rs 50,000. According to the data provided by the National Housing Bank, this would cover about 85 per cent of total borrowers and all borrowers from low-income groups
Tax incentives for saving
As far as support to savings is concerned, the view of the Task Force is that the implicit costs of the present structure of tax incentives outweighs the benefits.
Our proposals will lead to lower tax outgo for all assessees and consequently set off any perceived increase in tax liability arising from the elimination of directed savings in specific instruments. It is noteworthy that there is no unambiguous international evidence that the overall savings rate of an economy is influenced by tax breaks on specific savings instruments.
A concern has also been voiced in the comments on the Consultation Paper that by increasing the limit to Rs 1 lakh, a large number of taxpayers will escape from the tax net. These apprehensions are misplaced. For the wider goal of increasing the tax revenue-to-GDP ratio, the key question should be the total income that is being brought into the tax net, and not the number of taxpayers. Surely, a simple toll tax would bring more taxpayers, but that would not give buoyancy to the tax-GDP ratio. Also, most taxpayers with incomes of up to Rs 1 lakh will continue to file returns on account of the one-by-six scheme and, therefore, the concern that they drop out of the tax net is misplaced.
Now we move to the implications of our proposals. First, by removal of the various exemptions, we are in fact enhancing transparency as well as increasing the quantum of income in corporate and personal that will attract taxes, albeit at lower rates. Second, by reversing the trend over the last two decades of an increasing burden upon the income group between Rs 2 lakh and Rs 5 lakh, we would be bringing more income into the taxnet due to improved compliance.Since the continuation of the one-by-six scheme is recommended, there would be a steady accretion to the number of tax returns filed, and with an improved tax information system, the tax base would be further enlarged.
We should also note that international comparisons regarding the minimum level of taxable income, against our proposed Rs 1 lakh, are not fair. This is because unlike other countries, Indian families with less than Rs 1 lakh in annual income pay much higher quantum of indirect taxes on the goods and services that they consume. Regarding our proposals to tax agricultural income, there was considerable support as it promotes horizontal equity and captures agricultural income of non-agriculturists. However, a number of observers have made a point that it could result in considerable administrative difficulties and increase transaction costs for agriculturists. Given the proposed exemption level of Rs 1 lakh and other systemic reforms that have been recommended, the Task Force believes that administrative problems may not be insurmountable. However, it is entirely for State governments to consider our proposals in this area, given the Constitutional provisions.
Tax as a tool of developmental policy
Tax exemptions are opaque since their incidence as well as implicit cost is non-transparent. Further, the present exemptions raj promotes rent-seeking behaviour, and contributes to the complexity in tax laws. In terms of administration, exemptions more often than not lead to tax leakage and tax abuse thus increasingly making the system counter-productive and dysfunctional. Consequently, it has increased tax rates for tax-complying sectors, thereby leading to an all-round increase in the ex-ante costs of risk (equity) capital in the economy. This affects investment, growth dynamics and employment generation.
Today, full tax-paying corporations, including small and medium, enterprises pay almost 50 per cent tax ex ante on risk (equity) capital since they can avail of only few, if any, tax exemptions; on the other hand, certain classes of corporations that are privileged to access these exemptions pay much lower taxes. Clearly, there is cross-subsidisation. Moreover, such exemptions mean greater complexity, which burdens the tax authorities further and leads to an increasingly antagonistic relationship between the Revenue official and the taxpayer. This complexity is one of the major reasons for tax leakage and tax abuse. Hence, the Task Force is of the view that this is not an efficient way of achieving the developmental objectives and that there are better and more efficient alternatives to achieve these goals. For instance, if we want to promote investment in economically-backward regions, the government should give an up-front capital subsidy to a project in place of tax exemptions. Such an expenditure-based instrument will make the policy transparent and directly accountable through the CAG audit to Parliamentary oversight. Yet another important set of comments received, particularly from the corporate sector, related to the need to observe the doctrine of promissory estoppel. According to this doctrine, a Government should maintain the promises that it has given even if these are not contractual. This doctrine was particularly referred to in the context of tax exemptions relating to 80IA & 80IB and 10A & 10B. We would like to make several observations in this regard:
In fact, our proposals improve the lot of the shareholders as for them we are eliminating not only dividend tax, but also capital gains tax. Consider what is being proposed: Currently, there are firms which pay no tax on profit, while their shareholders pay dividend tax at 30 percent and capital gains tax at 10 per cent, which are (indirectly) taxes on profits. Our proposal is to charge 30 per cent tax on all corporations, and remove the dividend tax and capital gains tax (on listed equity).
Since the Task Force could not reach unanimity regarding the treatment of profits of computer software exports, even after discussing these issues in depth, it has suggested two possible alternatives to mitigate the tax problems faced by the software sector. The first is the elimination of exemptions under sections 10A & 10B together with retention of an amended Section 91 (to partially offset the burden). The second is retention of these15exemptions until a totalisation agreement is ratified with trading partners, simultaneously with taxes being levied on dividend distribution and long-term capital gains.
Towards strengthening the financial system
There is another more profound relationship between the proposed tax rationalisation and modernisation of the financial sector, and this is from improved allocative efficiency. The decision to incur capital expenditure will now depend on return considerations rather than tax considerations. The recommendations of the report are aimed at greatly simplifying and rationalising the tax system. This will better focus investment decisions of households upon an evaluation of the underlying risk and return of alternative investment avenues, without distortions induced by tax considerations. It will hence help us obtain a system of financial market prices that reflect risk and return.
Implementation options for corporate tax reforms
It was unanimously agreed that it is rather difficult for any government to give a credible ex-ante time commitment. Such commitments are rarely sustainable. Past experience shows while tax rates were reduced, successive governments failed to implement measures for strengthening the tax base, for example, phased withdrawal of incentives. As a result, we have reached a point where the corporate tax rates are close to their resting points and yet the statute continues to be riddled with exemptions and deductions. Any attempt to sequence the reduction in the corporate taxes and the withdrawal of exemptions and deductions could lead to disastrous impact on revenue flows, particularly taking into account the proposed reduction in the personal income tax rates.
The two must necessarily be implemented simultaneously. Phasing also gives rise to uncertainty and `hope' that reforms could be reversed. There is an additional factor in favour of Option I. Given the present weak state of the international economy, the proposed package has the potential to impart a strong counter-cyclical boost to the Indian economy by promoting domestic demand ñ both consumer demand as well as investment demand. A number of influential economic analysts in India have argued that our industrial economy is facing a cyclical slow down and our package would meet this challenge.
There were also concerns expressed by a number of NGOs and charitable organisations. The concerns were regarding our proposal for the use of rating agencies. While NGOs accept the principle, they suggested that the details should be fully worked out before implementing it. We have modified our proposals in this regard, giving more time to all concerned to adapt to the new procedures.
The Task Force at the outset recognised the importance of evolving a strategy, which would considerably enhance the ability of the tax administration to detect and penalise non-compliance. We decided to first address various issues that impact on the effectiveness of tax administration. Tax policy issues, dealt in the later chapters, are essentially addressed to improve the core functions of the tax administration, that is, to improve taxpayer services and to enhance deterrence against tax evasion. The underlying philosophy of the report is to substantially alter the economics of tax evasion.
The cost of compliance is proposed to be drastically reduced by simplifying the tax laws and reducing the tax rates. The emphasis on taxpayer service through extensive use of information technology will enable the department to promote voluntary compliance amongst the general class of taxpayers and identify the `hardcore' tax evaders.
Similarly, the cost of non-compliance is intended to be increased substantially by establishing the Tax Information Network (TIN), which will enhance the probability of identification of tax evaders as well as help in the detection of income evaded. It will also substantially improve the quality of evidence against tax evaders and enable successful prosecution.
We accept these shortcomings and, in this report, we have endeavoured to make our proposals as clear as possible and to provide necessary tables to support the recommendations. Further, we recommend that the Central Board of Direct Taxes should regularly make available data on CD-ROMs to scholars and analysts. This will help in encouraging indepth research and analysis of the tax data and other economic trends. Such research will be of vital importance for improving our tax policies.
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