The Hindu Business Line : Fewer tiers, less tears

THE report of the task force on Implementation of the Fiscal Responsibility and Budget Management Act, 2003, under the Chairmanship of Dr. Vijay Kelkar, was submitted on July 16, 2004.

One may recall that the Finance Minister in his Budget speech for 2004-05 indicated in more than one place that this report would broadly be the basis for Budget 2005-06.

The report of the Task Force is now available for public consumption and analysts have started discussing the merits and demerits of several proposals. There is no doubt that sufficient research has gone into the conclusions drawn in several areas in the report.

The subject of personal income-tax always attracts attention since a majority of the 34-million taxpaying population are worried as to what would be his/her tax outflow in any new dispensation.

This naturally raises the issue of what is the ideal exemption limit or threshold level to determine the tax liability. The Task Force has analysed the historical growth of personal income-tax and has arrived at some interesting conclusions.

Exemption limit

Taxpayers below a certain income level are exempt from tax primarily because the social cost of effecting such a transfer outweighs the social benefit. In most countries, the exemption limit is automatically and annually adjusted for inflation.

In India, there is the cost inflation index in order to arrive at the cost of asset to compute capital gains. But this concept has so far not been incorporated to revise the exemption limit.

The reasonableness of the threshold limit of Rs 50,000 and the proposed limit of Rs 1 lakh has to be considered with reference to a benchmark point in time.

It would be interesting to look at the pattern of growth of exemption limit and income at which the peak rate applies. (see Table)

The report discusses two alternative methods of adjusting the exemption limit.

First, taking 1950-51 as the base year and Rs 1,500 as the exemption limit, if one were to adjust this for inflation, the corresponding amount for 2004-05 would be Rs 46,500. This is lower than the current exemption limit, which is effectively at Rs 1,00,000.

However, the exemption limit has to be substantially higher to make the present average tax liability comparable with that of 1950-51 levels. An alternative way of determining the appropriate level of exemption limit is to use the net social benefit from collecting taxes from the marginal taxpayer.

If the costs of administration and compliance were zero, the ideal exemption limit would also be zero. The need for an exemption limit arises from the willingness to forgo revenues in order to save on collection costs. Experts believe that the optimal exemption limit may actually be much higher than those existing.

This is primarily because of the very high compliance costs for small taxpayers. Therefore, there is a strong case for raising the exemption limit, but there is equally a compelling case for directing policy measures to simplifying compliance procedures.

Dropouts

Any Finance Minister has to reckon with number of taxpayers `slipping out' of the tax net on account of increasing the threshold limit.

It is precisely for this reason that while Rs 50,000 is proposed to be upgraded to Rs 1 lakh in the Finance Bill 2004-05, the process of effecting this is by giving a tax rebate under Section 88D and keeping 14 million existing assessees in the tax net, though effectively not paying any tax.

A counter viewpoint to this proposition is that in a dynamic environment, the income-earning ability of taxpayers increase overnight and the so-called `dropouts' will get to the tax-fold purely on account of increase in their income.

There is no empirical study to test the veracity of this proposition. There are several cases of assessees filing incomes just at the minimum threshold limit and paying marginal tax.

The problem of pushing the exemption limit is not merely of numbers, but also one of `quality of taxpayer' vis-à-vis `quantity of taxpayers'.

There is no doubt that an increase in exemption limit will result in revenue loss. It is also established that in an era of large-scale tax evasion, no foolproof system can be devised to ensure that every rupee earned is properly disclosed.

The recommendation of the Task Force is to push up the exemption limit to Rs 1 lakh and have only two rates, that is, 20 per cent up to Rs 4 lakh and 30 per cent beyond Rs 4 lakh. Another argument in favour of increasing the exemption limit is linking the limit to the per capita income.

This is pure economic theory and one is not sure whether this can be applied in a country with so many economic variations across various States.

Nevertheless, the theory goes on the presumption that there is a misconception that the exemption limit as a proportion to per capita income is higher in our country compared to those prevailing in other countries.

The report highlights that "unlike in the developed countries, a relatively higher proportion of revenues in India is collected from indirect taxes. Since the indirect taxes are also levied on items of mass consumption, individuals with low per capita income also end up bearing the burden of taxes disproportionate to their ability to pay. Any additional burden through direct taxes would be excessive.

"For comparison, it is necessary to evaluate the total tax burden at different levels across countries rather than the burden of direct taxes only. Such comparison will suggest an upward revision of the basic exemption limit."

The large middle class and salaried population will welcome the proposed exemption limit as propounded in the report. The two-tier rate structure — 20 per cent and 30 per cent — is undoubtedly simple and can be easily administered.

The question is: Will taxpayers respond by disclosing their true incomes and can the economy make them generate sufficient income in a manner that the so-called `dropouts' come back into the tax fold notwithstanding pushing up the exemption to Rs 1 lakh?

There are other significant aspects in personal taxation in the report which is closely linked to the proposed changes in the slab rates.

(The author is a Chennai-based chartered accountant.)