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Monday, Aug 09, 2004

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Kelkar report on FRBM — Discussion at various levels a must

S. Venkitaramanan

The Kelkar Task Force report deserves wider discussion at various levels, including representatives of the corporate community, affected tax-payers and State governments.

I HAD touched on certain recommendations of the Kelkar Task Force (KTF) on Fiscal Responsibility and Budget Management (FRBM) Act in my article on the subject last week. I propose to reflect on the remaining recommendations in this piece. These recommendations mainly concern direct taxes and compression and containment of public expenditure. So far as direct taxes go, the latest proposals of Kelkar more or less reiterate the main substance of the first Kelkar Committee. The emphasis is on removal of exemptions while effecting better compliance, mainly through lower rates and better integration of the income-tax network in the direct taxes department.

So far as removal of exemptions is concerned, the KTF proposals seem to take into account the comments of various observers. These were to the effect that corporates and individuals had acted on the bona fide belief that exemptions will continue.

Although the KTF denies the principle of promissory estoppel as applied to Government, it has agreed to "grandfathering" some of the exemptions. Those exemptions, which have been acted on by individuals and corporates as of date, will continue, in effect, in respect of those who have so acted. "Grandfathering", a statute, is a typically American expression, which gives currency to existing reliefs as a result of earlier enactment.

One hopes that in the Indian context, it will not give rise to writs alleging discrimination in favour of those who benefit as a result. The KTF proposal of grandfathering is, however, a practical way-out of a dilemma, faced by corporates, who had incurred large investments in the expectation of continuing IT exemptions.

The KTF also recommends that the range of tax incentives for savings needs rationalisation. It dismisses fears about the adverse effects of such removal on savings in the country as a whole. This is, however, a debatable conclusion. The KTF recommends that tax rebate under Section 88 be eliminated. So too, the exemption of interest income under Sections 10(10D), 10(11), 10(12) and 10(13) be grandfathered in respect of investments already committed to these instruments and schemes.

Similarly, deductions under Section 80(CC) would be eliminated under the KTF's proposal. The KTF, however, proposes to introduce "grandfathering" in respect of these exemptions also. Contributions to existing accounts of PPF will cease to enjoy tax rebates after abolition of Section 88. However, the interest earned on amounts outstanding will continue to enjoy under certain Sections.

The "grandfathering" option does not destroy the justification for the exemptions. The revenue and so-called equity considerations seem to have influenced the KTF's view.

Under the grandfathering option, what it amounts to, in effect, is for instance contributors to PPF will cease to enjoy rebate after the proposed abolition of Section 88 while interest earned on the amounts outstanding will continue to enjoy exemption. There will, however, be the complication that employees will be required to open new accounts.

Under the KTF's proposals, a new scheme known as the Individual Savings Account (ISA) is to be introduced for pension contributions. This will be in two parts. The mandatory pension contribution will flow into Tier-I and will not be allowed to be withdrawn till the contributor attains the age of sixty. All other contributions will flow into Tier-II, which can be withdrawn by the contributor at any time. There will be no lock-in period for Tier-II.

The tax treatment of the ISA scheme will be on "Exempt Exempt Tax "(EET) method, whereby contributions as also accumulations will be fully exempt from the tax base. But, the final withdrawals, including those in the event of death, will be included in the taxable base at the appropriate marginal rate of tax.

The maximum contribution to the ISA scheme will be Rs 1 lakh per annum. All withdrawals from the scheme will be subject to a TDS at 20 per cent. However, the TDS rate seems too high for the average saver. The Government should tread warily before it introduces this simple-sounding, but essentially complex, experiment, lest it affect personal savings.

I now turn my attention to the KTF proposals on corporate tax. These are well-intentioned, but may affect overall investment. One of the KTF's two alternative packages for corporate tax reform centres on the proposal to reduce corporate tax to 30 per cent while lowering depreciation rate from the existing 25 per cent to 15 per cent.

Correspondingly, the KTF also recommends that depreciation rates for other blocks of assets should also be reviewed. The arguments cited in favour of the proposed reduction involve a detailed calculation, which purports to show that given the availability of VAT on capital goods and current depreciation rates and interest rates at 8 per cent, the depreciation allowance will amount to an accumulation of internal accruals much in excess of the original cost of equipment — an unintended net gain to the tax-payer!

While this calculation is certainly impressive, corporate managers may be able to demonstrate that it does not take into full account the actual effects of wear and tear of equipment, particularly in the extractive and chemical industries. It would also be desirable to have a comparative study of the rates of depreciation in vogue in competing economies, relevant especially in a globalising situation.

It is important to remember that internal resources of enterprises, which depend on accumulated depreciation, do account for the fast growth of enterprise in many countries, including those in the South-East Asian economies.

It has also to be recognised that developed economies have even at times resorted to "expensing" out the entire capital expenditure in the first year itself to induce industries to develop their capital base. Witness the depletion allowance introduced in the US to encourage oil exploration. In the UK and the US at different times in the recent period, increased depreciation and investment allowances encouraged investment.

One would have expected the KTF to have supported their recommendations with suitable references to comparable depreciation rates in vogue in competing economies, like China as also in other countries of the developed and developing world.

Tax reform has to meet the dual challenge of equity and incentivisation for development. The KTF should have measured the desirability of its recommendation against the touchstone of a comparative analysis of incentives provided in respect of direct taxes in various competing global economies.

The KTF has also suggested dilution of tax incentive for infrastructure projects in the hope they can be substituted by straightforward grants. This is subject to the following infirmities. It is a rather weak argument to say that corporates, which invest in infrastructure, have nothing to lose as in any event they have an assured rate of return and the costs are passed through.

It is surprising that Dr Kelkar, who presided over the dismantlement of the administered price mechanism of p.o.l., should have cited Government "assured" returns as an argument. Exemptions offered by the Government in respect of infrastructural investments concern mainly the garnering of cash flows that accrue for investment.

"Assured returns" are also very fragile in the case of many investments, including roads and waterways, not to mention independent power producers, vide the case of CESC and Dabhol. The KTF is carrying its pursuit of equity concerns to an extreme when it tries to deny the legitimate tax concessions offered by Government for encouraging essential investments in infrastructure. Further, experience with such region-based direct budgeting grants has not been satisfactory, particularly in other countries, like the UK. In relation to better management of expenditure, the KTF makes a suggestion that the CAG should concentrate his attention on audit of outcomes instead of auditing expenditure alone. While well-intentioned, the suggestion may tend to mask the main purpose of the CAG's audit, which is constitutionally enjoined to be a monitor of expenditure according to budget appropriations. True, there is no harm in enlarging the scope of the CAG's audit.

But the purpose of the KTF's suggestion for an audit of outcomes may be better served by suitably constituted evaluation teams, which go beyond the minutiae of expenditure and accounts and look at outcomes. That is an area, which calls for revival of independent evaluation of organisations at both Central and State levels. They should include representatives of the CAG as well as experts in the concerned technical field, besides representatives of civil society. Overall, I must grant that the KTF's report is a thought-provoking document, which deserves discussion at various levels and participatory interactions with members of the corporate community as well as representatives of affected tax-payers and State Governments.

The Finance Minister has a long enough period before he has to decide how to incorporate the KTF's proposals in his next Budget — for 2005-06. The weeks and months ahead must be a period of introspection for both the KTF as well as those who happen to fall within the scope of its far-reaching recommendations.

Here is to hoping that the present Government will spare no effort in facilitating transparent discussions on the KTF report and fully take into account every reasonable criticism before taking its final decision.

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