The revised paper on Direct Taxes Code (DTC) put out by the finance ministry has been a subject of discussion in the media. The revisions have been made on the basis of the representations received from various stakeholders on the draft released in August 2009. Importantly, even as the new version accedes to the demand to continue concessions in many areas that were originally proposed to be withdrawn, it does not propose to expand the personal income tax brackets to Rs 10 lakh and Rs 25 lakh, and, thus, avoids losing a substantial tax base.
The revised draft makes a number of changes in the draft Code and in the process will have lesser scope for expanding the base. On personal income tax, it continues the EEE regime for permitted savings on the grounds that there is no universal social security and the change would entail many administrative, logistical and technological challenges. The proposal to tax perquisites has been substantially pruned and, in particular, the proposal to include the market value of rent-free accommodation given by the employer has been given up.
Inclusion of notional income from the owner-occupied house has also been abandoned. The revised draft proposes to include long-term capital gains from financial securities, but take only a portion of the gains. For non-profit organisations, it allows carry over of up to 15 per cent of their surpluses or 10 per cent of gross receipts, whichever is higher, to be used within three years. The Code proposes to grandfather area-based exemptions, but allows profit-linked exemptions to the developers in SEZs only up to the unexpired period.
On corporate taxation, the proposal to levy MAT based on the gross assets has been given up and the tax will continue to be levied on the basis of book profits. The revised Code follows the international practice of considering companies as residents if their place of effective management is in India. It clarifies that in case of differential interpretations between the Code and the double-taxation agreement, the one which is more beneficial to taxpayers will hold, unless the anti-avoidance rule is invoked.
On wealth tax, the proposal to levy the tax on the value of unproductive assets has been abandoned and the tax will be confined to the value of productive assets. It also clarifies that the General Anti-Avoidance Rule whenever invoked will be within the scope of the Forum of Disputes Redressal Panel.
The government must be commended for adopting the consultative approach to finalising the Code. Besides making the reforms acceptable, the approach will make politically difficult reforms feasible over time. As the finance minister mentioned in his 2009 Budget speech, tax reform is a process and not an event. Therefore, even after the adoption of DTC, further simplification and rationalisation will be needed suiting to the requirement of the times. Furthermore, DTC is only a part of the reforms in the tax system. Reforms in tax administration and information system, including induction of technology, are equally, if not more, important.
There is a larger issue of how far the government should reduce the effective tax rates. In the Laffer curve formulation, revenue increases with the tax rate up to a point, but thereafter, increases in the rate will cause decline in revenues. There is an implicit belief in all those who argue for further reducing the rates that we continue to be on the declining part of the curve. Thus, Surjit Bhalla, in a recent article (June 30, 2010), has argued that reduction in the effective rates of tax due to widening of the brackets proposed in DTC is very desirable, but alas, the finance minister does not intend to expand the brackets in the revised Code!
Bhallas contention is that the sharp increase in revenues since 1997-98 was due to the Laffer effect and stagnation in revenues in the last few years was due to steady increase in the effective rate of tax. Therefore, the governments decision to reduce the effective rate of tax by 6 percentage points in 2008-09 and a further 2.6 percentage points in 2010-11 is sensible and this is rewarded by Mumbai TDS yielding 18 per cent higher revenue this year! First of all, between 2002-03 and 2007-08, contrary to his contention that the revenues were stagnant, the personal income tax revenue recorded an unprecedented annual average growth of 30 per cent. It is only due to this that the so-called effective rate in his calculations showed an increase.
In other words, his effective rate can increase or decline simply due to revenue increases, which may or may not be due to changes in nominal rate. Second, the decline in the effective rate in 2008-09 was not due to any decision of the government, but simply due to lower tax payment by small businesses. It must be noted that the personal income tax category includes individuals, Hindu undivided family, association of persons and small businesses. In fact, the population that paid the tax in 2008-09, the last year for which audited figures are available, was 32.7 million which was lower than the previous year by 3 per cent.
Tax compliance is a function of tax rates, probability of detection and penalty rate. Surely, reduction in the marginal tax rate in 1997-98 could have had a favourable impact on tax compliance. However, it must be noted that reduction in the rates was accompanied by administrative measures to expand the scope of TDS. The revenue from TDS, which constituted just about 20 per cent in 1996-97, increased to almost 67 per cent in 2000-01. Since 2003-04, the single-most important factor that increased revenue productivity (and thereby Bhallas effective rate) was the institution of the Tax Information Network (TIN).
In 2002-03, less than 25 per cent of those who were supposed to deduct the tax at source actually submitted the returns and this increased sharply since TIN was put in place. Consequently, revenue from income tax increased by about 30 per cent per year from 2003-04 to 2007-08. Of course, tax rates matter, and so is tax administration. Reducing the rates without improving administration and information system to increase the probability of detection is a recipe for disaster. Fortunately, tax brackets and rates are not a part of DTC in the revised Code.