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Tax code ignores development
January, 29th 2010

The tax code comes in the economic background of over 400 million people being below the poverty line; with many areas disturbed due to underdevelopment; sustained policies of inclusive growth having reduced the poverty ratio but not absolute numbers; and a huge lack of infrastructure . The present tax laws have been one of the enabling tools for GDP growth of 8%. The accompanying table indicates the stupendous pending developmental task with a clear focus on lowincome states.

Economics with a pragmatic approach must therefore prevail over classical economic theory if it spurs capital formation , inclusive development, and employment . In Indias context, this must be the litmus test. The code, while simplifying law and reducing tax rules and removing exemptions, appears to have been designed primarily as an instrument of plugging all loopholes even overturning legal tax-relief provisions and precedents; and giving unprecedented subjective powers for this.

It simplifies and reduces personal taxes but with substantial deferred taxes on savings. Monetary stimulus helped India to overcome potential recession; similarly tax stimulus helped regional development and employment. A reading of the table will lay the bare facts. But the objectives of development and employment have not been the driving force of this code.

Consider incentives for infrastructure and industries in backward hill states. Presently they enjoy normal depreciation (approximately 90% in six years) as well as 100% and 30% tax holiday for specified periods from five to 15 years. This is being substituted only by 100% accelerated depreciation for infrastructure industries; generally their sale prices are controlled by regulators.

Tax-holiday policy improved net returns (ROI) and hence drew huge investment into these sectors. Over 60% has come from fund investors. Secondly, infrastructure funds will lose pass through status thus increasing tax incidence. Minimum alternate tax (MAT) computed at 2% on gross asset book value (under company law accounts) without future set off will increase the tax incidence on book profits as accelerated depreciation is only computed for tax, not accounting.

These measures will impact ROI; product price; and cascade on downstream products affecting agriculture and manufacturing; where energy and transport costs are major cost elements. For example a 500MW power plant costing Rs 2,500 crore will bear 2% MAT of Rs 50 crore.

This would raise the annual cost of power produced by the plant by 6% above Rs 900 crore. Can we afford to lose competitiveness for global fund flows in infrastructure? The power capacity growth lag is a moot witness. Further, is the economy ready for a cost push in basic goods which will affect global competitiveness of manufacturing?

Monetary stimuli averted national economic recession. Region specific tax stimulus measure of 100% direct tax exemption and indirect tax for specified periods boosted investment, employment and development of Uttaranchal and Himachal Pradesh, where it was supported by infrastructure and law & order; while failing in other places without the latter.

It reduced migration and diverted youth from antisocial activities. The government should replicate this tax stimulus in Maoist areas. This authors plea is only for tax exemption to infrastructure undertakings anywhere and to manufacturing in disturbed areas.

THE employment:capital ratio and output: Capital ratio is much higher in the MSME units as compared to heavy industries. These have low capital assets and will exhaust accelerated depreciation in 4-5 years. The area-specific tax holiday stimuli should continue at least for MSME plants (if not to all) in disturbed areas if put up in next seven years (supported by holistic development) to stimulate fast employment generation.

The Maoists will then lose their raison de etre. The code cannot be an island in itself; its framework must give this enabling power to the government. Mr P Chidambaram , the main author of the code, will perhaps support this as home minister.

The discussion note states Para 12.23 Such area-based exemptions create economic distortions i.e. divert resources to areas where there is no comparative advantage... and lead to tax evasion and avoidance. In principle, in an ideal economy, we cannot dispute this.

But large parts of India i.e. Bharat have not developed to that stage. The answer to tax evasion is faster computerisation and GST. VAT in excise duty and sales tax led to an over 25% boost in revenue and reduced evasion; process will be intensified with GST. Would you rather have inclusive development and employment or worry about allocation of resources and 5% evasion?

Reduction in personal income-tax is a welcome measure and will broaden the tax base. However, incentives for savings are being whittled down. EET is being introduced, capital gains tax reintroduced on quoted share/units investment transactions replacing the administratively much simpler security transaction tax. Investment in residential house as a means of capital gains exemption is being sharply curtailed .

Interest on loans for housing can only be adjusted from rental income. Construction has been the highest employment generator the world over. The code is disincentivising this. Our savings rate at 36.8% is well away from Chinas 56% an imperative for economic growth. Reduction in personal taxes will help; but will EET encourage consumption vis--vis savings? The substitution of STT system by the new system will divert savings from productive equity investment to rent seeking.

The LAFFER CURVE strongly demonstrates that tax revenue shall further increase with lower rates. The experience of many countries shows 20% to 22% to be an ideal rate leading to stronger compliance and higher economic activity. Stronger technology input in accounting and tax administration will curb evasion and boost revenue.

In Indias development situation, we need the proposed lower rates, combined with early GST and continuing a fine-tuned tax stimuli for regional infrastructure development and employment.

In seven years, we can again review the need for tax stimuli. In the interregnum , let us actively pursue the disinvestment policy to generate Rs 50,000 crore annually for budgetary resources to offset tax stimuli losses.

Developed India should move towards classical system of low tax with no exemptions and developing India i.e. Bharat should be supported by tax stimulus which promotes inclusive development and employment with holistic development.

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