Corporate tax rate reduction: To retain or remove exemptions
December, 03rd 2015
The decision to lower the corporate tax rate to 25% from 30% over the next few years sounds alluring. The tax cut would also go along with rationalisation of a plethora of benefits provided to corporates on various grounds that help to lower the taxable income. This appears to be a transparent way of setting the house in order, where the taxable income is what one sees in the accounts that is subjected to lower tax rates. Logically, this can be extended also to the household level, which the Direct Taxes Code spoke of, where tax rates are lowered and exemptions dispensed with.
The Budget document for FY16 on revenue foregone by the government reveals some interesting numbers. For FY14, the average effective rate of taxation was 23.22% for a large set of 5,60,000 companies while the statutory rate averaged 33.22%. In fact, including the dividend distribution tax, the effective tax rate worked out to 25.47%. The effective tax rate is the actual tax rate paid by the companies on the reported profit before tax as in their accounts.
Against this perspective, the future rate of 25% seems to be broadly restating the currently prevailing numbers without all the exemptions. Prima facie, this appears to be a prudent thing to do as the system becomes transparent and predictable with less scope for any kind of evasion or camouflage. The documents also talk of the ‘revenue foregone’ under various heads for corporate taxes, which for FY15 had a revenue impact of R98,000 crore (without adjusting for MAT). The major components were accelerated depreciation (~38%), deduction of export profit from SEZs (~19%), scientific research (~8%), power (~11%), etc. Clearly, we have been targeting specific areas to give a push which was in the form of deductions or exemptions to spur investment or activity in areas of high priority. The underlying assumption is that companies on their own may not be interested in going into these areas until such time there are incentives provided, given the risk-return matrix considering the gestation periods. In fact, even while depreciation can be called capital replacement, such allowances provided an incentive to spend on fixed assets which helped in capital formation.
While simplicity is a cornerstone of a tax system, there would always be a compulsion to balance the same with incentives. A tax system is not just about collecting money, which can be used to run the administration and bring about distributive justice, but also a means to spur the economy. It is not just a flow of funds from the productive sectors to the government, but also a means for incentivising entities.
For example, an investment allowance that is tax deductible is useful to channel funds for investment which otherwise could be disbursed to shareholders as dividend or reside in the books under the reserves and surplus category. At the individual level, giving exemptions on, say, interest on housing loans not just helps in creating purchasing power for households, but also provides a boost to housing industry. There is hence justification for incentives.
Doing away with incentives to get in simplicity and transparency would necessarily push back the motivations for certain acts. It is also true that often when incentives are provided there would be a tendency for companies to ‘cheat’ and take advantage of the clause while not really adding value to the objective, thus generating ‘perverse incentive’. It is not surprising that several companies have managed to become zero-tax ones by taking advantage of all these tax breaks, which inspired the concept of minimum alternate tax (MAT). If this was the reason to make the system less opaque, the solution would be more to provide the benefit only on fulfilment of the objective.
Hence, by going in for a simpler system that is transparent, the government may not be able to target specific objectives. Of late, the incentive provided for the backend support for agriculture, including logistics, was required to get in funds in an area which hitherto was underdeveloped mainly due to these ventures not being too profitable as standalone businesses. This may be lost in case of withdrawal of exemptions.
This is a tough call for the government to take as there are compelling arguments on both sides. One may recollect that several policies in the past involving incentives for investment in backward areas or even, for that matter, setting up SEZs have not quite yielded the intended results and may have also led to the destruction of resources. The new format of just simplifying affairs seems a logical outcome from this experience. The solution may be to rationalising these breaks where they did not work; or setting strong performance indicators to claim the same, which may not be easy. A tax holiday for, say, 5 years which ends with a stalled project cannot come under punitive measures even when the same is revealed as the enterprise will not be able to pay it.
An interesting outcome of such a decision by the government on the revenue side would also generate sufficient discussion on the expenditure side. The area under focus is cess which is imposed for different purposes by the government that is targeted at certain expenditure. Ideally, it should be removed when we have a single tax rate. There have been some questions about how the money that is raised via a cess is utilised since it does not fall in the purview of the Finance Commission’s ambit. Currently, the education cess in FY15 was around R31,000 crore. This concept should also be dispensed with.
As we move towards GST, which will be a single rate for state and central taxes, it does appear that the logical corollary is also to do away with various exemptions so that the system will work better. There will be a tradeoff with ‘initiative’ in case specific areas need special attention through incentives. Therefore, a fine balancing act is required to ensure that we do not lose this advantage, especially at a time when we are struggling to enhance the capital formation rate which has been ruling in the 27-28% range for the last few years. A question for which we still have to conjecture an answer is will the new format involving lower tax rates with few breaks work the Laffer way and encourage investment?