At a broad political and philosophical level, the draft direct taxes code unveiled last fortnight by Pranab Mukherjee and P Chidambaram has many interesting dimensions. Just imagine the political capital the UPA government will reap among Indias growing middle classes once the direct taxes code replaces the present Income Tax Act in 2011.

Of Indias individual taxpayers, 97% will be charged income tax at only 10%. The new code levies only 10% income tax for a taxable income of up to Rs 10 lakh. Only the remaining 3% of taxpayers fall in the higher taxable income slabs of beyond Rs 10 lakh. The rates for these are prescribed at 20% for up to Rs 25 lakh income and 30% beyond it. We are told these slabs may even be indexed to inflation so that not many changes to income-tax rates be made for a long time. In a sense, one may only see expenditure budgets in the future as there will be no tax rate or exemptions to tinker with!

If the direct taxes code is implemented in its present form, the budget of 2011-12 will be as much of a dream budget as the one in 1997, at least for individual taxpayers. The UPA will bag the political dividends this will generate in the 2013 general elections. This should certainly worry the main opposition party which is currently undergoing a bloodbath over Indias pre-independence history.

The proposed direct taxes code seeks to lower the rates while doing away with exemptions at both the individual and corporate levels. At a broad philosophical level, the new income tax code is also an invitation to the rapidly rising class of individual traders, shopkeepers and small businessmen to come clean and declare their income at effective tax rates of 10% to 15%. This is what is expected to widen the tax net hugely and increase compliance.

The incentive to small businessmen to come into the income-tax net will be further strengthened by a transparent goods and services tax (GST) regime which will seek to capture all businesses along the value chain with a clean one-time indirect tax to be shared by the state and Centre.

In a sense, the direct taxes code has to work in tandem with a GST regime which will ensure a large number of small businesses come into the income tax net. So the GST should actually result in a major widening of the income-tax net.

For instance, a small contractor in the construction space, with an annual taxable income of Rs 15 lakh, may be avoiding paying income tax because he buys most of his materials without official billing to avoid cascading local taxes. But with a simple and transparent one-time levy of GST the contractor may bring his activity into the official channel and also pay the new effective tax of around 12.5% on his income.

This is precisely what the direct taxes code and the GST are betting on. At a political and philosophical level, both these frameworks actually attempt to correct the historical tax bias in favour of the capital-intensive big businesses. In the last few decades of the exemption raj, most big businesses hardly paid any tax as they kept availing of accelerated depreciation and other tax holidays provided to drive investments. This can be established by just looking the number of companies that pay just the minimum alternate tax (MAT).

On the other hand, largely labour-intensive small manufacturers, who obviously did not enjoy these exemptions, paid much higher income tax. The income-tax policy, in general, was weighted a lot more in favour of big businesses.

The new direct taxes code seeks to correct this imbalance with two clear strategies. One, it intends to phase out all tax holiday regimes, mostly used by capital-intensive big industry, by grandfathering them till they phase out. Second, these businesses will have to pay a MAT of 2% of the gross assets as shown in their balance sheets, if they do not have taxable profits.

There is maximum protest over this provision coming from reputed law firms who mostly represent the interests of big business. They are describing this as a sort of wealth tax being introduced through the backdoor. The authors of the new code argue that this is a sort of efficiency tax which ensures that businesses flog their assets optimally. For instance, in the real estate space, companies are known to accumulate land banks and wait for these to appreciate before building on them.

A 2% tax on the vacant land will force the real estate company to build faster. So goes the logic for levying the 2% tax on gross assets in lieu of MAT. Apparently this has been tried in other countries successfully, though the rate may be lower.

Overall, the new tax code and GST recognise that Indias business landscape today is very different from what it was twenty years ago. Small businesses will increasingly become the backbone of the growth process and tax policy must remove the bias against them.