The Hindu Business Line : In search of the tax rate nirvana

"Bad government, inadequate infrastructure and high tax rates came in the way of India attaining the same pace of growth as China although both nations started reforms in early 1990s."

— Fortune, October 31.

THERE is growing concern over the rate of tax to be imposed on corporate profits and also on the income of the non-corporate taxpayers. World over, tax rates are on a decline. Countries have come to realise that high tax rates are counter-productive and lead to evasion. There is also the feeling that lower tax rates may induce companies to make large investments.

In fact, there is growing tax competition among several countries. Tax havens have come up in several parts of the world. Slabs are being re-visited and exemption limits being raised. Recent attempts by India to modify the slabs in the tax rates only reflect the global trend.

The British debate

Great Britain was the first country to introduce the income-tax law two centuries ago.

The idea was to finance the war against Napoleonic France. Income tax accounts for 30 per cent of all tax receipts in the UK.

Surprisingly, there is now a debate even in Britain about the desirability of continuing with the progressive tax system. The Conservative Party, in Opposition, set up a commission in September 2005 to explore the possibility of introducing a flat tax in Britain. The present slabs and rates in the UK are:

Tax-free personal allowance — £4,895

First £2,090 pounds of taxable income — 10 per cent

Next £30,310 pounds — 22 per cent

Income above £30,310 at 40 per cent

Advocates of the flat tax regime consider that such a regime, with fewer exemptions, will improve administration and confer economic benefits.

The Economist points out that the latest edition of Tolley's Yellow Tax Handbook, which contains all direct tax legislation for 2005-06, runs to four weighty volumes and has roughly doubled in length ever since the Labour Party's Gordon Brown became Chancellor of the Exchequer in 1997.

One advantage can be that low-paid people will go out of the tax net. The old argument about incentive to work because of a simple tax regime has been revived.

The progressive principle is taken care of by the fact that the rich will pay a higher proportion of their income than the poor. They cannot exploit the tax code to take advantage of loopholes.

The Adam Smith Institute has proposed a flat tax rate of 22 per cent, which is the current rate, arguing that all taxpayers would be better off under the reform. The tax-free personal allowance will be doubled. There will, however, be a sizable loss of revenue. According to research, the current yield of income-tax could be maintained with a flat rate of 30 per cent and a personal allowance of £10,000. Low-earners and high-filers will gain; those in the middle-income group will stand to lose.

The recent German elections were fought, among other issues, on the question of tax reform.

Paul Kirchof, a former judge and professor from Heidelberg, proposed a 25 per cent flat tax. He would like to get rid of not less than 418 tax loopholes and subsidies. The German tax law, argued Prof Kirchof, is a fast-growing weed that has covered the `garden of freedom'.

French tax reform

The French Prime Minister, Mr Dominique de Villepin, decided to simplify tax bands and rates. The top rate was lowered from 48 per cent to 40 per cent. The number of income-tax bands was reduced from six to four, with the lowest rate of 5.5 per cent on an income of $6,700 and a top rate of 40 per cent on earnings of 10 times this amount.

The long list of over 400 tax-deductible expenses will be trimmed. The tax reform will benefit low-to-middle-earners.

Comparative capital taxation

A Canadian think-tank has come out with a well-researched report on capital taxation by several advanced countries. It has been pointed out that a mere comparison of statutory tax rates on corporate incomes will miss several factors that affect the effective tax the companies pay.

Governments use different routes for the treatment of depreciation and the inventories. This causes divergence of actual tax rates from the statutory figures. The authors of the report have worked out a Table comparing effective tax rates on the basis of the proportion of pre-tax return on capital swallowed by the State. The Table indicates the statutory effective tax rates on capital in select countries in 2005. Tax rates are on the decline in Germany, the US and Canada.

Chinese experiment

The basic tax exemption level in China is low and this has meant a rapidly growing group of taxpayers. The threshold limit has been stagnant at 800 yuan ($99 a month) for the past quarter of a century. There is a proposal to nearly the double the exemption limit.

According to the Central University of Finance and Economics, raising the exemption limit will reduce the number of income-tax payers by 10 per cent and income-tax revenues by 20 billion yuan a year. The present basic exemption limit was set at a time when the average monthly income was just 40 yuan.

The average income is now over 700 yuan a month. Media surveys highlight the fact that the taxpaying public will be happy with a tax threshold of 2,000 yuan a month.

According to the Head of the Central University of Finance and Economics, China failed to collect as much as half the income-tax owed by the taxpayers.

Many Chinese states have scrapped the agricultural income-tax levied on peasants. The question of income-tax rates and slabs has been thrown open for public debate.

World Bank recommendation

The World Bank has made a number of far-reaching suggestions in this regard:

The tax base should be as broad as possible. The income-tax base should also be broad, covering all incomes, from every source.

Tax rates should be as low as possible.

Personal income-tax collections should be raised by closing loopholes and enforcing greater compliance.

Greater use of property taxes.

Consider inheritance taxes.

Avoid implicit taxes such as bribes and inflation.

Every one of these recommendations can be implemented in India, but what about the last one?

(The author is a former Chief Commissioner of Income-Tax.)