The new Direct Taxes Code (DTC) has been put in the public domain and will most likely be up for debate in the monsoon session of Parliament. There are three major components to the code personal income taxes, treatment of capital gains, and corporate taxes. This and the next article will talk about the first two.

But first, some deep congratulations to all those, and especially the UPA government, for daring to change the landscape. The credit largely goes to the present Home Minister, P Chidambaram, who, in his previous avatar, introduced wide-ranging tax reforms in early 1997. Then, starting in May 2004, he started his campaign again, and while there were some missteps (e.g. the fringe benefit tax, banking transaction tax), the overall thrust of tax reforms under his leadership has been immense.

And now the credit goes to the man for all seasons (and all policies) Pranab Mukherjee. We have been witness to a flurry of activity since his arrival on the scene in 2009. First, the successful fire-fighting with the Great Recession, then the introduction of long overdue rational pricing of fuels, and, of course, the presentation and championing of the DTC. A noteworthy feature of this new policy is the transparency and humility with which it has been handled. It has been up for debate, and the government is listening. Whether it continues to listen, especially on its rather non-economic, non-logic and ideologically inconsistent recommendations on capital gains tax, remains to be seen.

But there are many, including some senior economists/journalists, who question the DTC on its recommendation of personal taxes. Their belief is that the DTC is a giveaway, i.e. it has reduced the effective tax rate for all individuals by too much. If these learned people were younger, they would be chanting down with imperialism, down with fascism, down with capitalism and the government recommendations will only make the rich richer and the poor poorer. Further, according to the learned, this is a particularly bad time for giveaways because India has a major debt and deficits problem. And finally, the critics add, only 30 million or 3 per cent of the people in India pay taxes (this news is received with much applause by those who believe in rank populism). The 3 per cent figure is broadly correct. But not much more should be expected!

The reasoning is straightforward. First, the universe is not the total population but the worker population, and this is 40 per cent of the total.

Second, only non-farmers pay income taxes, and farmers are about 10 percent; so the relevant population universe is 300 million, not a billion. Given that not everybody who has income is eligible to pay taxes (there is a minimum exemption which, for the fiscal year 2009-10, is Rs 1.6 lakh per earner), the number of people in the taxable bracket goes down still further.

In 2007-08, the last year for which returns data are available, about 74 million workers were eligible to file tax returns, and 33 million did (see table). This means that only 7.4 per cent of the population should be filing taxes, and the fact that 33 million did is bad, but 45 per cent compliance rate (ratio of 33 and 74) is much, much better than only 3 per cent (the compliance rate is expected to have averaged 39/69 or 56 per cent in 2009/10).

The critics have a second arrow; they come armed with the following (and only!) fact in their favour, i.e. there has been stagnation in personal income tax (PIT) revenues. In 2007-08, PIT collections were Rs 118,000 crore, and in 2009-10, Rs 125,000 crore. Worse, the critics argue, the budgeted tax collections with the new 2010-11 code is only 121,000 crore.

While the bare facts are correct, the critics miss the whole picture. First, that there has been a phenomenal over-the-top increase in PIT since tax cuts were first introduced in the 1997-98 Budget. The effective tax rate (defined as the tax rate applicable to the tax-paying population) in 1996-97 was 16.8 per cent. The next year, the effective tax rate was reduced by more than 6 percentage points to 10.2 per cent, and in 1998-99, a recession year, the tax rate went up to 11.6 per cent. What happened to PIT revenues? They went up from Rs 18,000 crore to 21,000 crore, a 17 per cent increase (the 1997-98 tax collections are tainted by collections due to the tax amnesty VDIS).

How did tax revenues go up when tax rates were going down? Because of the Laffer effect, or the compliance effect. As tax rates are raised, more and more people cheat, and cheating takes two forms under-declaring your income, or not filing tax returns. As tax rates decrease, the reverse gear operates less people cheat, and tax revenues increase. Which brings us to the stagnation of tax revenues in the last few years. Note the steady increase in tax rates since 2002-03 in 2007-08, the effective rate was 15.7 per cent, almost identical to the peak tax rate of 16.8 per cent in 1996-97! Any wonder then that the government made the sensible decision of reducing the effective tax rate by 6 percentage points in 2008-09 and by a further 2.6 percentage points in 2010-11? And taxpayers are rewarding the good sense prevailing: Mumbai TDS returns for April 1 to June 9 are up 18 per cent over last year; and this, based on the reduced tax code!

There is logic and substance behind the governments new tax code. As the Indian landscape has changed, so has the tax code. Let us applaud the change, especially since this is a rare instance of the government being a few steps ahead of the so-called civil society intelligentsia.