Here’s to Budget 2005

Indian Express, 12 February 2005

Crafty tax reform will keep both payers and exchequer happy

Prime Minister Manmohan Singh and Finance Minister P. Chidambaram have both promised that Budget 2005 will be a budget of tax reforms. The challenge of budget making consists of simultaneously addressing India’s fiscal crisis — which requires increased tax revenues — and supporting growth of the economy. What are the tax reforms that we should see in this budget?

The tax that touches most readers directly is the personal income tax. Recently, Dr Parthasarthy Shome, advisor to the finance minister, said that income tax slabs should be linked to inflation. This has not happened in India. If we look at the historical data for income tax slabs and rates, we find that rates were highest in 1973-74 when there were 11 slabs and the peak rate was 97.75 per cent. If we compare the present rates to the inflation adjusted levels for that year, we find that today’s rates are higher. So, for example, in 1973-74, the tax rates of 10 per cent and 20 per cent were applicable for incomes up to Rs 10,000 and Rs 20,000, respectively. The corresponding inflation adjusted numbers are Rs 1 lakh and Rs 2 lakh. But the current slabs are Rs 1 lakh and Rs 1.5 lakh for 10 per cent and 20 per cent. The adjustment for the 10 per cent slab was made last year. The finance minister should raise the slab for 20 per cent to income above Rs 2 lakh in Budget 2005. In accordance with this, the slab for 30 per cent should be raised as well.

Another reform on personal income tax that is on the cards is changing the tax treatment of savings. Currently, a number of savings instruments get tax exemptions at three levels: saving are exempt, interest income on them is exempt, and final withdrawals are exempt from taxes. This is called an “EEE” treatment — the first E for exemption of saving, the second E for exemption of accumulation, and the third E for exemption of withdrawals.

This triple exemption is considered to be bad tax policy. The Kelkar task force recommended that all savings be made EET: savings would remain tax exempt, interest income would remain tax exempt, but taxes be paid at the stage of final withdrawal. But people who have already saved in various EEE savings instruments like provident funds and post office savings would feel cheated because they made the decisions on the basis of the tax treatment. The way out is to “grandfather” old savings. Existing investments would live out as originally promised, but all incremental savings would become EET.

Tax reform is also needed in corporate taxes. In an economy where labour is relatively more abundant than capital, it is natural to favour employment-intensive technologies. But India has had a pronounced heavy-industry bias in the strategy for planned industrialisation since the late 1950s. This bias was also apparent in the structure of tax incentives. The tax system has been biased against employment by allowing a high rate of depreciation of capital. This allowance brings down the amount of tax to be paid by a firm. While capital-rich advanced countries have a depreciation rate of just 10 per cent, a generous rate of 25 per cent was offered to capitalists in India.

When an entrepreneur or a venture capitalist evaluates two alternative projects — one labour intensive and one capital intensive — a depreciation rate of 25 per cent generates a bias in favour of the capital intensive project. The consequence of this policy has been to slow down employment growth in the organised sector.

This pro-capital and anti-labour bias in the tax structure needs to be remedied, by reducing the depreciation rate. In the Kelkar task force report this rate is proposed to be reduced to 15 per cent. The proposal of the Kelkar task force also offered a grandfathering of investments, so that current factories do not get affected. To offset the impact of lower depreciation, the KTF proposed to charge a lower rate of corporate tax on companies. It was proposed to be reduced from the current rate of 37 per cent to 30 per cent. The reduction in the depreciation rate would marginally increase the tax burden on industry.

In the sphere of indirect taxes both the prime minister and finance minister have supported the Goods and Services Tax (GST) recommended by the Kelkar task force. At the central level this requires the introduction of a Central GST by bringing up the tax rate on services as well as adjusting the CENVAT rate (excise on goods) to one single rate. The rate recommended by the KTF was 12 per cent. It also means integrating the excise on goods (a reduction from the current rate of 16 per cent) and the service tax (raising from 10 to 12 per cent) into one single IT system. An array of exemptions exist for both CENVAT and service tax. The finance minister needs to introduce a negative list for services that says which are the services that will not be taxed, rather than saying which will be taxed and face opposition on those. Services such as health, education, life saving drugs and government services could form part of the negative list. In customs also there is a need to remove a large number of exemptions that exist and bring rates to one or two rates.

The last time, in 1997, when P. Chidambaram was faced with the difficult issue of removing exemptions, he chose to cut rates but let exemptions stay. This time he cannot afford to do that if he is to meet his FRBM targets. However, when exemptions go and rates are cut at the same time, most of us will find that at the end of the year we are better off. As lower rates generally increase compliance, the additional tax payers who start paying their taxes will push up the government’s revenue collection. The latter may not happen immediately but in a couple of years the government would also find itself richer.

Ila Patnaik

Ila Patnaik