Listen, Mr Chidambaram

Left wants tax exemptions gone. Crony capitalists don’t. A happy context for reform

P Chidambaram will receive a million pre-budget suggestions by end-February. But the one he must take seriously, he has already received — the Left has hammered home the point that he must take a sickle to the weedy field of tax exemptions.

Exemptions not only lead to a loss of revenue, they also complicate the tax system, are iniquitous and encourage evasion. They create rent-seeking interest groups who do not allow the exemptions to be removed long after they have served, or failed to serve, their purpose.

For instance, under the corporate tax structure, incentives are given for exports by allowing exemptions to profits made when goods and services are produced in and exported from Free Trade Zones (FTZ), Special Economic Zones (SEZ), Electronic Hardware Technology Parks and Software Technology Parks (under sections 10A and 10B). There is a complex treatment of profits from domestic and on-site and off-site sales as these are treated differently. Since these parks already have better infrastructure, they already enjoy a competitive environment. Tax exemptions for them violate the principle of equity and require complex monitoring. Moreover, as the Left has pointed out, India is no longer suffering from a shortage of foreign exchange. Exports are growing at a high rate because India is competitive and there is no need for the government to lose revenue to provide further incentives to exports.

In addition, if India wants to promote exports, a much more powerful way to do it is to rationalise indirect taxes through a countrywide VAT. Countries with a low and well-implemented VAT based goods and services tax (GST), which is based on consumption rather than production, and which by its very nature does not export taxes, have an advantage in exports compared to countries that have high and inefficient cascading taxes. Under the present corporate tax structure, incentives are given for backward area development, infrastructure, and so on (under sections 80IA and 80IB). These include exemptions for up to 100 per cent of profits for up to 10 years from various activities. These include profits from infrastructural projects like toll roads, bridges, highway projects, ports and airports, telecom, development of special economic zones and transmission, generation and distribution of power. Exemptions are available for small scale enterprises, industries in backward states and backward districts and shipping.

Hotels in pilgrimages and hilly areas, which started operations before 2001, get an exemption for 50 per cent of profits, while in other areas hotels get exemptions from corporate tax up to 30 per cent of their profits. Multiplex theatres and convention centres are eligible for exemptions for 50 per cent of profits for five years. Not only is this “industrial policy” a hangover from the days of planning and socialism — where the government chooses what is good for the people — incentives for backward areas and other specific locations have not served their intended objective. They have also caused serious distortions in economic efficiency, equity and administrative effectiveness. If incentives for backward areas need to be protected, that should be done by a direct expenditure grant, not through exemptions.

Tax exemptions inevitably create interest groups who benefit from them and who oppose any change in the incentive structure. This usually makes it very difficult to terminate, or even phase out, the incentives. There has, for example, been opposition to the government’s plan to phase out exemptions given to profits from export income. Until now the finance minister has not given in to these demands and hopefully will now be under greater pressure to ignore them. Not only should the finance minister take up the Left suggestion to remove exemptions for corporate tax, he should use this opportunity to also address the same issue in tariffs. An absurd number of exemptions (nearly 2,000) exist for custom duties. These were imposed at a time when custom duties were high. Now that duties have come down — they peak rate is 15 per cent and may come down further to 10 per cent — there is no place for the exemptions. Not only do the exemptions lead to loss of revenue, they also creates scope for corruption.

As a result of the exemptions when two different consignments of the same item are imported into India, they could encounter very different tariffs. The exemptions are based on who is importing, or why he is importing. If the imports are for defence, police, training, education, oil exploration, exhibitions, expeditions, for export purposes such as packaging materials, durable containers, by charitable institutions, for handicapped persons or for sports related activities, exemptions from custom duty is given after due paper work. The importer gives the appraising officer the relevant literature and a certificate from one of the 33 approved certifying agencies, such as the Director General of Foreign Trade, the Director of Vanaspati, Vegetable Oil and Fat, the Council for Leather Exports or the Sports Authority of India. The importer has to get a Bill of Entry from the appraising officer. The most important advantage of removing exemptions would be that it would do away with the multiple contact points with the government. These involve enormous costs of compliance, since appraising officers have to get engaged in questions of both valuation and end-use.

If there is reason to give some exemptions, for example, to life saving drugs or to security equipment, a custom duty refund should be given instead. At the point of entry there should be no difference in the treatment of consignments. This will not only get rid of the historical backlog, a lot of which are irrelevant now, it will also make the subsidy transparent and bring it on budget. Most important, it will reduce the involvement of officials and raise compliance.

Budget 2005 was a budget of rationalisation of direct taxes. Budget 2006 should be a budget removing exemptions. It is rarely that a finance minster has the good fortune to face political pressure for the kind of reform that normally economists advocate and politicians oppose. He must seize this opportunity.

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