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Cracking the tax code
June, 17th 2010

The UPA has regressed a bit by diluting a code for direct taxes that held out the promise of a rules-based system India has been in crying need of for most of its independent history. The politically acceptable version of former Finance minister P. Chidambarams brainchild is a throwback to decades of discretionary taxes so riddled with exemptions that it becomes well nigh impossible to lower rates or widen the net. Indias tax revenue has never exceeded 13 per cent of its national income.

Meagre pickings for a country that needs to take a third of its people out of poverty, provide them rudimentary healthcare and equip them with the basic skills needed to survive in a modern economy. Lower taxes, spread across a bigger chunk of the population have demonstrably yielded higher revenue to the exchequer, it is a pity lobbying has claimed a principle-driven approach that could have delivered.

Individually, though, the revised provisions are not without merit. The absence of a social security net sets a premium on precautionary savings, which can be incentivised by preferential tax treatment. Likewise, the original proposal to tax assets, and not profits, of companies paying the minimum alternate tax would be a drag on investment decisions.

The securities transaction tax and the wealth tax in their present form are policing measures to keep funny money out of asset classes, these needed to morph into effective taxation of capital gains. The clarification on a sunset clause for tax giveaways in special economic zones remains true to the spirit of the code to do away with the jungle of exemptions that has grown around the Income Tax Act, 1961.

The Centre reckons it lost 6.5 per cent of the GDP last year in taxes foregone through exemptions. If it can arrest this haemorrhage Indias tax to GDP ratio could rank alongside the economies that comprise the Organisation for Economic Cooperation and Development. It will also meet the European Unions club membership rule on the size of its fiscal deficit.

Although we are far from the tax apparatus available in the West, where rates change rarely, if at all, India needs to get there if it is serious about becoming a well-regulated free market.

The direct tax code, even in its watered-down form, tries to limit giveaways and, therefore, is a return to horizontal equity. The withdrawal of exemptions is not a painless process, as the UPA has discovered, but is well worth the effort if tax revenue afterwards is less leaky and thus not exerting a continuous upward pressure on rates.

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