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Direct Tax Code fails to bring
August, 24th 2009

What does the new direct tax code (DTC) seek to achieve? Will it add an impetus to the India growth story or will it turn to a burnt baked cake that More Pictures will spoil the party? How about households, investors and businesses? Will their lives change once the new tax code gets implemented in financial year 2011? Before we begin to examine these issues in detail, let us check the DTC vital stats.

An ideal direct tax regime should be simple to understand and administer, equitable and progressive, and reward economic activity and above all it should provide buoyancy to the governments revenue. Does the proposed tax code stand these tests?

Consider the first aspect. The new tax code is indeed simple to understand and will go a long way in reducing the ambivalence and discretion which plagues the existing Income Tax Act, 1961. The new tax code seeks to leave little scope for multiple interpretations and will thus curb disputes and litigation, something very common with the existing Act.

The new code is in fact a completely new tax law aiming to simplify the direct tax regime in India and has tried to capture the best international practices. This new code also attempts to make direct taxes equitable by introducing moderate levels of taxation and expanding the overall tax base. The DTC attempts to simplify the legalities to enable better understanding so as to ensure a higher degree of compliance.

For instance, the new directive has done away with different heads of income. The two broad heads of income would now be income from ordinary source and income from special source. The first head would include income from employment; house property and business while the second head would include capital gains on equity and equity oriented funds and income of any other nature.

On the face of it new DTC endeavours to make the direct tax more equitable and progressive, however in actual practice it fails this test. Through the new regime has greatly expanded the current income slabs; the lower slab has been left unchanged.

The first slab continues to start at Rs 1.6 lakh and extends all the way to Rs 10 lakh and the highest tax slab now kicks in at Rs 25 lakh. Combine it with the abolition of various exemptions and deductions and most of the taxpayers, especially the salaried people will end with a higher tax bill than they pay right now. For detail calculations refer to the story ' Not Bharat Friendly '.

In contrast, those with income of Rs 10 lakh and above will see a decline in their tax liability. The new regime also provides high-income earners with greater avenues of tax-exempt savings and investment options by tripling annual investment limit to Rs 3 lakh. People in the low-income category will also be hit by the proposal as it abolishes the exemption on HRA benefits and home loan interest for self occupied property.

However, if the same house or second house is given on rent, the person will get tax benefits on interest payout and that too, unlimited interest payment. Obviously the government seeks to favour landlords over tenants.

The new regime also seeks to discourage savings in general and is thus pro-consumption. India has a saving rate of almost 35% while most of the developed countries have the saving rate (ratio of gross national savings to GDP) around 14-20%. It proposes to introduce exempt-exempt-taxation (EET) method and taxing capital gains may discourage saving.

Removal of distinction between the long term and short term capital gains and taxing them at respective slab rates of individuals is another shocker. Those already in highest tax bracket may be negatively impacted while those in lower tax rate slabs may be positively impacted. For details refer to the story titled ' No More a Saving Grace '.

But will the new regime promote economic growth or make the Indian economy more efficient? Faster economic growth needs higher savings and investments while efficiency requires squeezing more out of the existing assets or capital. By reducing the effective tax burden for those with the higher propensity to save and invest (individuals with income of Rs 10 lakh and more), the new tax code may improve the chances of economic growth.

By reducing corporate tax rate, the new regime also seeks to incentivise India Inc to grow their revenues and profitability. By linking minimum alternate tax (MAT) to gross assets rather than profits, the new regime seeks to encourage companies to make most of their existing assets rather than go on an asset creation binge which is quite common right now. This is a step in the right direction and investor friendly. For details refer to the story titled ' MAT change to discourage asset creation '.

At present, India has a low tax-to-GDP ratio of around 10% and there is enough scope for improvement. For developed countries this ratio varies in the range of 30-40%. Will the new regime provide the government with ammunition to plug the rising gap between government expenses and the tax revenues? There are two ways to achieve this. Induce existing payers to pay more tax or bring more people under the tax net i.e. expand the tax base.

The new regime will make taxpayers pay more which may raise revenues. But those in higher income bracket may now play less tax so the net effect is difficult to gauze. The greatest source of buoyancy may however come from the capital gains tax, which will now become universal. Government may get tax windfall from the migration to EET method from EEE method in case of longterm savings such as insurance products, new pension scheme and provident funds among others.

While the proposal is put forth for public debate, its implementation would not happen until 2011. Amidst all the pros and cons of these proposals, the noteworthy fact is that an initiative has been taken to bring in simpler direct tax regime that can facilitate higher consumerism. It would be interesting to see what shape the final tax code takes and whether it retains its current structure as it is.

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