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The tax rate reduction versus incentives conundrum
October, 06th 2015

The 2015 budget speech of finance minister Arun Jaitley had several confidence-inspiring announcements; targeted rationalisation of corporate tax rates was definitely among the most enthusing ones. Since then, the government has continued to hold fast to the promise of a definitive roadmap to reduce tax rate to 25%, over four years beginning 2016. Interestingly, the UK Chancellor, in his July 15 budget speech, echoed Jaitley’s views—the UK tax rates, though, shall fall from 28% to 20% (further down to 18% by 2020). No surprise here, though: The idea of a tax rate reduction to align with global median rates (OECD and Asian rates) was first sown in 2009, when the draft Direct Taxes Code (DTC) was unveiled. DTC has been shelved, but the spirit of a tax rate cut for business continues, keeping in mind job creation and investment in the economy.

Here lies the challenge—the reduction has to be in tandem with a calibrated phase-out of tax incentives and exemptions which businesses have benefited from, given the different programmes rolled out by successive governments in the past two decades.

It is meaningful to plod through statistics to put this reform initiative in perspective. By 2014, the world median corporate tax rate had clawed down to 22.6%; corporate tax rates amongst 34 OECD members and 44 Asian countries were 25.2% and 20.8%, respectively. Even amongst emerging nations (BRICS and G20), the top marginal rate hovered around 28%, at least 5% points below India’s. India’s own macro-economic statistics reveal useful trends—Economic Survey 2015 suggests that despite a higher tax rate, the effective tax collection rate is 23% (little over 25% if one includes the dividends-distribution tax). The difference between the two benchmarks is explained by plethora of tax exemptions to sector- and geographic-specific economic activities.

One is thus inclined to ask—is a high maximum marginal rate (MMR) an undesirable incongruity, particularly, if viewed from the tax-collection prism. On the other hand, such higher tax rate, coupled with woes of compliances and incoherent tax jurisprudence, causes disquiet amongst investors.
Statistical distribution of incentives

Most of the tax holidays are extended to export, manufacturing and infrastructure activities— developer and units in special economic zones, manufacturing or production, development of infrastructure facilities (road /ports/highway, etc.), electricity generation and distribution, exploration and production of hydrocarbons. Quantum of foregone revenue in these sectors constitutes nearly 80% of the government’s revenue foregone.

The Revenue Foregone Statement published for FY14 reveals that the effective tax rate (ETR) for corporates was 23.22%, below the MMR of approximately 34%. Amongst sectors, manufacturing had the lowest ETR (nearly 22%), on account of high incidence of exemptions. ETR for the service sector was recorded as 24.37%, largely due to SEZ benefits. This partly explains the correlation between revenue foregone and exemptions.

Most eligible sectors would pay the Minimum Alternate Tax (MAT); MAT is, however, not necessarily a cost as accumulated MAT credits are allowed to be set off against corporate tax in subsequent years.

Statistics presents a compelling case for rate reforms through recalibrating tax incentives programmes. The moot question before the budget drafters is: How to achieve it?
The ‘how’ of incentives reform

Incentives announced by successive governments were premised on the objective to catalyse investments in focal areas to achieving macro-economic growth targets. It won’t be entirely incorrect to anticipate that eliminating all existing tax incentives could indeed be counter-productive to certain sectors. What is required is to identify incentives, sorted according to the decreasing order of their dispensability and devise a phase-out plan around such order of preference. A case in point is incentives for manufacturing in the form of accelerated capital write-off. This is de minimus to encourage investments. Moreover, an accelerated depreciation is merely a timing issue, not necessarily an incremental tax advantage. Tinkering with these basic tenets of tax incentive regime may not yield much, but can risk disruptive trends in the sector, besides going against the grain of the Make-in-India campaign.

Similarly, tax incentives for individual taxpayers (including senior citizens) have socioeconomic ramifications and offers little room for manoeuvring.
Perhaps, export incentives ought to be relooked, particularly in times when India’s forex reserves are staggered and export units benefit from a favourable exchange rate. An instance of such phase-out occurred in the Finance Act of 2000, presented by then finance minister Yashwant Sinha, when he resorted to the withdrawal of tax exemption for exports. Similarly, former finance minister P Chidambaram refused to budge under pressure to extend tax benefits to software and export-oriented units, in the successive budget of UPA regime.

The task is cut out for the FM: Rolling out an implementable roadmap to realign tax rates and incentives, without causing a disruption in the investment cycle, is going to be a tightrope walk.

Equally important, it will be incumbent to deliberate if there is a compelling case for continuing with parallel regimes for tax computation—MAT and normal tax provisions. Or, whether there is a case in line with the government’s drive to achieve simplification of tax regime to consider taking away the arbitrage in computational methodology, once extant tax incentives have been largely withdrawn in principle. All of this requires deep introspection and impact analysis.

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