The Hindu Business Line : Going overboard on tax sops?

Tax reforms have succeeded in boosting India's openness through large tariff reductions and lifting the share of direct taxes in total revenue but the fact remains that the overall ratio of tax revenue to GDP has not risen significantly, leaving the Government to face a heavy debtburden, says T. C. A. RAMANUJAM.

The Prime Minister, Dr Manmohan Singh, has warned State governments against the unhealthy practice of providing unsustainable tax-breaks and fiscal incentives to industrial projects in their bid for faster growth. "In the excitement to have headline- grabbing MoUs," said Dr Manmohan Singh, "we offer incentives both fiscal and financial, which our finances cannot sustain".

Tax reforms may have succeeded in boosting India's openness through large tariff reductions and lifting the share of direct taxes in total revenues, but the fact remains that the overall ratio of tax revenue to GDP has not risen significantly, leaving the Government to face a heavy debt burden. According to an IMF study, the tax take in India is 3.5 percentage points below the average for all emerging countries. The average tax rate on labour and capital in India is well below that in the more mature emerging markets of Asia.

Low effective rate

In an IMF working paper, Ms Helene Poirson points out that a relatively narrower tax base, pervasive tax incentives, low personal capital gains tax and a large informal sector have contributed to the low average effective tax rate. On the other hand, consumption taxes are high. Whereas India with a corporate income tax rate of 35.9 per cent generated a revenue of 2.3 per cent of GDP in 2003, Singapore raised 3.5 times that revenue with a rate of just 22 per cent and Chile raised twice that revenue with a rate of 17 per cent.

The tax code bristles with distortions. It favours finance through debt over equity and retained earnings. The widespread use of rebates, exemptions and special regimes for specific sectors in regions have retarded growth in tax revenues. Firms relying on internal financing are penalised. So also equity financing.

To remove these distortions, the IMF paper suggests limiting the deductibility of interest to a percentage of net taxable income, limiting debt for the purposes of income-tax, limiting interest to a referential rate, and introducing an allowance for corporate equity. There are 162 ways of avoiding or reducing direct taxes.

The Flawed SEZ idea

The latest distortion concerns the policy of promoting Special Economic Zones imitating China, whose economic growth continues to be a mystery.

The IMF Chief Economist, DrRaghuram Rajan, hauled the Union Government over the coals in the September issue of Fund's quarterly, Finance & Development, pointing out how it would lead to uneven pattern of development and shift of investments to the new zones.

It is important for India, he said, to exchange its paternalistic, directive government, which seeks to remedy every wrong through a subsidy, a quota or a scheme. Even the Finance Ministry has calculated the cumulative loss of revenue to the exchequer in the next five years at Rs 1,75, 487 crore. Undaunted by criticisms from economists, the Reserve Bank of India, and Small and Medium Enterprises, the Centre has decided to go ahead with the SEZ scheme.

Who are the beneficiaries of the policy on SEZ? Mainly Corporate India, which seems to be rushing in, allured by the tempting prospect of avoiding huge taxes.

Every tax reform proposal implemented by the central Government in recent years has benfitted the wealthy. For instance, the exemption of dividends from taxation resulted in a whopping Rs 14,000 crore going tax-free (taking a sample of the top 500 companies). Formerly, the exemption was limited to Rs 12,000. The replacement of this exemption of Rs 12,000 by complete abolition on the tax on dividends and the introduction of the additional distribution tax effectively meant that the tax share of distributable profits falls more heavily on the small shareholders than on the promoter directors.

STT and STG

Former Chief Economic Advisor to the government, Dr Shankar N. Acharya, wonders how a turnover tax on financial transactions such as the STT of 2004 can be introduced at a time when taxation on value-added commodities is replacing turn-over-taxes at the Centre and in the States. He suggested modification by halving the rate of STT so as to reduce the efficiency cost. He suggested the doubling of the present rate of short-term capital gains tax so that it would be closer to the rates on capital gains from other assets. He also proposed the raising of the rate of the tax on long-term equity capital gains from zero to 10 per cent.

These suggestions fell on deaf ears in a regime, which believes that the boosting of the Sensex will mean a boost to the economy in general. The decline of Rural India has not been taken serious note of. Large agricultural farms go untaxed even when heavy commodity taxes cripple the poor peasants.

A small change in the definition of agricultural income and agricultural land would bring land sales within the purview of the capital gains tax, and income from land would attract income-tax.

A suggestion has been made that the prescribed distance from the municipal limits may be doubled to 16 km from the 8 km at present for defining agricultural land and agricultural income. It is high time that agriculture was not treated as a holy cow.

Obsession with GDP growth, the Sensex and foreign funds has led to what Mr Milowan Djilas graphically called the emergence of a "new class", which is not ashamed of displaying its newly acquired power through open consumerism and foreign travel jaunts.

It was J. K. Galbraith who argued that the greatest problem with economists was their "wilful denial of the presence of power and political interest". He decried the coexistence of massive private consumption with public decay.

Inter-State Trade, Tax Wars

There is competition among States to attract foreign investments. A stranger to the country will wonder if India is a quasi-federal state or a confederation of sovereign states vying with one another for foreign funds by offering to forego as much taxes as possible in order to see that the transnational set up plants in that State. The States are indulging in a trade and tax wars forgetting the harmful effects of tax competition.

The Prime Minister's warning could not have come at a more appropriate time. He was right on target when he pointed out that the largest barrier to trade is the tax system. "Free flow of trade," he said, "can add up to 2 per cent to growth rate across the region. Why have octroi, luxury taxes, mandi taxes, etc., when we can do with one common Goods and Services Tax across the country?"

The tax code is the country's main mechanism for redistributing income. Scaling back the subsidies would improve the efficiency of the economy and free up a huge amount of money. There is an urgent need for harmonising the system of taxation both at the States and at the Centre.

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