But old habits die hard. The public debate is often about each group justifying its exemptions and arguing for their continuation. With the latter, revenue will collapse as applicable tax rates fall. In the old India, different groups demanded and received special treatment. The question is; can each group give up its special treatment in return for an efficient system free of unproductive tax planning?
This depends on the extent to which the Code establishes incentives that are sensitive to the Indian context, in order to push towards a new India. The active use of loopholes demonstrates our response to systemic incentives.
Although the aim is to tax all income, agricultural income continues to be exempt. Exemptions are also to be given on grounds of equity, of externalities, to encourage human development, to reduce risk, and to reduce administrative and compliance burdens. Even so, making tax rates uniform will make it difficult to escape taxes. Popular loopholes will largely be closed. Thus there will be no area based incentives for firms, no exemptions for perks or for charitable institutions, and no lower rates for long term capital gains tax. The security transaction tax (STT) will be abolished, but taxes will be paid on all types of capital gain at the applicable marginal rates. Therefore, transaction costs will be lowered in markets, even while wealthy traders may pay more tax.
It needs to be debated if closing loopholes is now more important than the aims served earlier through differential taxes. Short-term trading is thought to dominate in Indian markets. In that case, is encouraging quicker turnover on the part of retail investors also desirable? The policy objective seems to be for households to switch to new savings instruments. Most households will continue to be reluctant traders, while more of their investments will be intermediated through mutual funds. Also, capital income must be taxed along with labour income.
The current system seeks to encourage net savings. The tripled three lakhs of tax-exempt savings will be taxed at the consumption stage. But given the new slabs, the tax applicable on withdrawals at retirement would be low. Even so, in moving to an exempt-tax treatment of savings, care must be taken to ensure that switching of exempt savings between instruments is not taxed, even if it occurs with some delay. Moreover, the new capital gains regime must not apply to investments made before 2011. At present, this concession is given only to the public provident funds (PPF) and so could encourage widespread sale of shares.
A consumption-based tax encourages savings, which is a desirable feature. But it can be regressive so it is to be supplemented with a wealth tax Moreover, the threshold of Rs 50 crore, after which a tax of 0.25 will be applied, is too high in the Indian context. Since more income will be left in the hands of lower income groups with a high propensity to consume, consumption will be encouraged.
The corporate tax rate will be lowered to 25 per cent, but after the removal of exemptions this will be slightly higher than the current effective tax rate. Foreign and domestic firms will be treated equally since the first will pay an additional 15 per cent branch tax and the second the dividend distribution tax. Investment expenditures will be tax-exempt in a shift from profit-based incentives to investment incentives. The minimum alternate tax (MAT), used to ensure some tax liability, will be calculated on assets rather than book profits in order to encourage use of assets. However, provision must be made for deferred payment if there are no earnings. Moreover, assets such as generators and roads, built due to the State’s failure to provide infrastructure, must not be included in calculating MAT, in order to put more pressure on the government to deliver.
For the new social contract to be credible, the State must also perform. Tax authorities need to be made more responsive. Penalties must be equivalent on both sides. For example, the penal interest tax on taxpayer delays is double that on government delays. To minimise court cases on procedural issues, the Board will have more discretion, although the appellate structure remains the same. But reducing litigation through one-sided discretion is not desirable. Mechanisms such as advance rulings can reduce uncertainty.
The tax deducted at source (TDS) retains complex multiple deductions at source, which individuals have to then reconcile with their tax bracket. In mature countries individuals submit tax returns.
New technology makes it feasible for banks and employers to give information to the tax authorities and to individuals who then pay tax themselves in one go. The Code can move towards such a real simplification with technology facilitating trust.
There are worries that the new slabs will reduce revenues at a time when rising debt calls for fiscal consolidation. But 2011 will be post-slump and robust growth will itself expand the base. The Tax Department asserts the changes will be tax neutral — they need to share the data on which this assessment is made.
There are other minor inconsistencies. For example, while medical expenditures are tax-exempt on human development grounds, salary earners are to pay tax on medical allowances. But overall, it is time to give change a chance in a rapidly transforming economy.
This article first appeared here in The Economic Times.