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Pranab-da, listen to taxpayers, not economists
January, 18th 2010

When Pranab Mukherjee gets up to present his second Budget in this stint as finance minister, he is going to be nobodys hero. Till last year, overflowing coffers, freebie politics and a recession threat ensured that finance ministers only had to give things away: loan writeoffs, tax reliefs, stimulus packages, et al.

This year, Pranabs cupboard is empty. He has nothing to give. He will first have to withdraw the fiscal stimulus perhaps in stages, but withdraw he must and then find ways to end free lunches in several places: petroleum products, fertiliser, and food, among others. He will have to end the accounting fudges under which subsidies for oil are not paid from revenues but out of borrowings and this stupidity is not even acknowledged as a bad practice.

He will have to unveil a roadmap to combine excise and service taxes into one common goods & service tax (GST) regime. He has multiple challenges on multiple fronts, and the only high card he holds in this game is public sector assets.

Given political backing, he can sell a part of the family silver and raise resources to plug the black hole in finances (over Rs 4,00,000 crore according to Pranab-das last Budget).

 
This is, unfortunately, a terrible way to raise money. Its literally like eating your seedcorn. No sensible farmer would ever do this. You may satiate your current hunger, but you wont have enough seeds planted for the next crop. Its self-defeating.

Pranab Mukherjee surely understands this, but while planning any new taxes apart from GST he needs to take note of our experience with taxes before introducing new ones. He should ignore the advice of economists and just consider what is feasible in the Indian context. Economists will fret about the tax-GDP ratio, and want more direct taxes (income and corporation taxes, capital gains tax, et al) rather than indirect ones (excise and customs, and now VAT and GST).

In the Indian scenario, however, it should be the other way around: we should have more indirect taxes, and fewer direct taxes, unless you make it impossible to evade it.

For example, the dividend distribution tax is a direct tax on dividend incomes captured entirely at the corporate end. There is no scope for evading it, and the receiver is also happy since he doesnt pay further tax on it. It should remain on the statute books because it has worked well for us.

Economists will also tell you that it is not a great idea to tax transactions; one should tax incomes instead. But economists live in the world of make-believe. What they suggest does not work in India. Like all sensible human beings, Indians dont like paying any tax on income, and the taxes that work best for us are those that are integrated with transactions.

This way, the taxes are subsumed in the price and no one notices. One example is the securities transaction tax
(STT), which the new direct taxes code seeks to abolish and replace with taxes on capital gains. The STT is collected centrally on all stock and futures transactions.

The tax gets added to the price of a stock and investors have learned to live with it. Theres also no scope for evading it, since all transactions are now electronic and there isan audit trail.

The main reason why investors like STTis that they pay no capital gains tax on long-term share gains, and very little (15%) on short-term gains. Pranab should not change the status quo in the name of reforming the system. STT should stay, and long-term capital gains should not be taxed. It can only lead to more evasion and heartburn.

Another tax that has worked well is the cess on petrol and diesel to fund road development. Once again, the customer is only aware of the final price of his fuel, and makes little effort to evade them. Money is collected easily and efficiently through a handful of petroleum companies. The tax works like a dream.

The central and state value-added taxes (VAT) also pass the test of efficiency. VAT ensures that the buyer of a product gets a tax credit on any tax paid by the supplier, and this serves as an inbuilt check against tax evasion. If the supplier hasnt paid excise (VAT, that is) on his inputs, the buyer higher up in the food chain doesnt get a tax credit, which in turn pushes up his tax.

Every subsequent buyer thus ensures that VAT is paid by his suppliers. Its delivered brilliantly, and the GST which is essentially a VAT on goods and services should also work fine. Pranab should not delay its implementation.

 
 
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