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Taxing inflows: Wrong time, wrong place
October, 26th 2010

Will the government impose a tax on capital inflows to curb the surge in foreign capital? The chances are remote, going by finance minister Pranab Mukherjees statement last week that the surge in FII inflows is not a problem and only reflects the confidence among foreign investors on the India growth story.

A few months ago, the Prime Ministers Office (PMO) also made it clear that it does not want to rock the boat on the tax treatment of capital gains made by foreign institutional investors (FIIs) investing in listed Indian shares.

It rejected the finance ministrys proposal to tax capital gains made by offshore investors who sell their shares a year after holding them, saying a change will dampen portfolio investments into the country. The proposal was dropped in the Direct Taxes Code (DTC) Bill.

So, FIIs that are investing heavily in Indian stocks for better returns will continue to enjoy tax breaks on long-term capital gains even after April 2012, if the Bill is approved in its present form. Foreign institutional inflows are likely to cross $20 billion in 2010. However, it is reckoned that a tax on capital inflows could make the country a less attractive destination for investors.

Brazil, however, taxed capital inflows to prevent a speculative bubble and further appreciation of its currency following the global crisis. Last week, it raised the foreign inflow tax and imposed more capital controls to check hot money inflows. This does not mean all economies should follow suit.

The International Monetary Fund, for instance, has said that the use of capital controls as a policy tool is justified if the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued and if the inflows are likely to be transitory. Clearly, no one size fits all and every country has to formulate its own strategy to deal with the problem of hot money inflows.

India should desist hasty tax policy changes whether they impact foreign or even domestic investments, now that the standing committee on finance chaired by former finance minister Yashwant Sinha, has started vetting the DTC Bill. In fact, Budget 2011 should steer clear of changes at the conceptual level, given the governments commitment to overhaul direct tax laws from April 2012.

The DTC Bill, which will replace the five-decade-old income-tax law, has proposed to lower tax rates for individuals and corporates from April 2012. It could undergo changes, based on the standing committees recommendations. All the more reason, therefore, for the government to go with existing tax policies for one more year.

However, in the run up to Budget 2011, corporates will push for lowering their tax burden and seek sectoral concessions. Today, companies enjoy a host of tax exemptions and, hence, their effective tax rate is significantly lower than the statutory tax rate of 30%. So, the case to lower the tax rate further but keeping exemptions intact is weak.

Likewise, demands for a cut in the tax rates for individuals cannot be ruled out, with food inflation showing no sign of abating. The government must address supply constraints and not dole out more tax concessions. Revenues are needed to meet the growing expenditure needs. The UPA-II government can take some unpopulist measures given that this is only its third year in office.

Two years ago, the government was forced to provide a stimulus through rate cuts and accelerated spending to bring the economy out of the woods. With the economy on a firm footing now, the focus should be on fiscal consolidation and not change tax policies to appease a few stakeholders.

The DTC Bill though has some radical policy initiatives including tightening regulation to ensure that India gets a share of the tax pie in cross-border deals. Already, the government has raised a `11,000-crore tax demand on telecom major Vodafone on a cross-border deal involving indirect transfer of Indian shares. The company has contested the claim and the Supreme Court is hearing the case. But disputes of this kind will cease if there is no ambiguity in law.

More changes are needed in the DTC Bill to broaden the tax base. These have to be well-thought through as we need simple and transparent tax laws to make the country an attractive investment destination. The government should not miss a historic opportunity and must prepare the ground next year to implement the DTC from April 1, 2012. Budget 2011 should, therefore, declare a holiday on new tax policy proposals instead of giving more tax holidays.

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