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India still needs the Direct Tax Code
November, 02nd 2015

In his budget speech in February, finance minister Arun Jaitley in effect said that the Direct Tax Code (DTC) was being buried. The appointment last week of a new committee to rewrite Indian income tax law should be seen against this backdrop. Jaitley had explained that most of the provisions of the proposed code have already been integrated into existing tax law. Jurisprudence under the Income Tax Act is also well developed—even though there is a massive pile of money stuck in litigation. The finance minister concluded there was no merit in going ahead with the DTC.

The die seems to have been cast. It may seem like a losing battle, but this newspaper still feels that the DTC in its original form should be brought back on the table. After all, as we thankfully saw in the case of Aadhaar, government decisions can be changed. The Narendra Modi government almost scrapped Aadhaar before it saw the light. Now the biometric identification programme is one leg of its social inclusion policy, when teamed up with mobile payments and the Jan-Dhan Yojana.

It would be far better if the government even now decides to go ahead with the original version of the DTC as the best way to reform the Indian tax structure, even though it is five years since the original bill was tabled in Parliament by the previous government. The radical promise of its original version had already been watered down in the subsequent political bargaining.

The original DTC is elegant in its design. Its main strength is a simpler tax code that does away with discretionary exemptions on the one hand while creating space for lower tax rates on the other hand. Jaitley has recently reiterated his decision to bring down the corporate tax rate to 25% in the coming years. That would still keep Indian corporate tax rates several percentage points above the median for the countries in the Organization for Economic Cooperation and Development or OECD (a gap that, among other things, acts as a perverse incentive for tax arbitrage through transfer pricing). A deeper tax cut needs the DTC.

Of course, it is quite reasonable for the revenue collectors in the government to worry about whether lower rates will further constrict the flow of money into the treasury. The DTC will actually help increase the tax base to deal with the problem of potential revenue loss. It is thus very important that the entire DTC architecture is accepted. As in the case with the goods and services tax (GST), a diluted version of the DTC undercuts its potential to transform the Indian economy. Some corner solutions matter.

Why does the DTC still deserve another chance? The economist will say that a clean tax code results in more efficient capital allocation in a growing economy. The tax consultant will know that it can dramatically reduce tax terrorism by undermining the discretionary powers of the tax department. The personal finance expert will argue that it can minimize the distortions in savings behaviour as well as reduce the incentives for mis-selling of financial products. It is also worth pointing out that a complicated tax structure in effect helps large business groups who can game the system with the help of a battery of in-house tax experts.

India should by now have put into place a new tax structure via the DTC and the GST. Our ratio of tax to gross domestic product is one of the lowest among emerging market peers. The small tax base reduces the ability of the Indian government to build physical as well as social infrastructure. The messy tax structure we have also has malign indirect effects, since it distorts the decisions of companies, investors and households. Think about the fragmented nature of production chains in India because of a surfeit of state taxes or the obsessive shopping for tax breaks that have led to so many wrong investment decisions by households.

The tax structure needs radical change rather than meddling at the corners. And that is why the original DTC should not be given up as a lost cause.

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