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New tax policy directions: Indira Rajaraman
August, 07th 2010

An asset-based MAT may be premature as any levy which asks for efficiency in the use of assets requires ease of exit for inefficient units.

An asset-based MAT may be premature because any levy which asks for efficiency in the use of assets requires ease of exit for inefficient manufacturing units, something India doesnt have.

The global crash of 2008 was bad for most people, but like all disasters, it marked an upward turn in the fortunes of some. Prior to the crash, whole seminars were held on the irrelevance of the IMF. Today the IMF has a new set of biceps after having presided over the rescue package for the Greek imbroglio, and is prepared with rolled-up sleeves to take on more.

Prior to 2008, fiscal policy analysts had just about the lowest standing in the economics profession, a tad above accountants. After the crash, their status has not exactly risen, but they are being asked, if a bit tetchily, to design tax policy such that exit from the fiscal stimulus is enabled through enhanced revenue, without diminishing public and private spending.

As it happens, there is a new (direct) tax policy in India with the draft Direct Taxes Code (DTC) circulated in August 2009, to replace the Income Tax Act of 1961. The DTC, incorporating some revisions issued in June, is to be placed before Parliament in the ongoing monsoon session.

The code aims at cutting out exemptions, thereby lowering tax avoidance and broadening the tax base. The broader base then serves as a platform for rate reduction, which will lower the benefits from, and hopefully the revenue lost to, evasion. So far, so good.

Ideally, a quantitative estimate should have been provided of avoidance under the present regime, and how much of that will be eliminated in the new code. Avoidance, unlike evasion, can be estimated from filed returns.

Fortunately, budget documents in recent years provide estimates, based on electronically filed returns, of revenue foregone from both direct and indirect tax exemptions, disaggregated by the relevant section of the code in each case. For 2008-09, the estimates carry the further advantage of being based on returns filed during the full fiscal year, because of the delay in budget presentation in 2009 to the month of July.

An exclusive focus on corporate taxation will help keep things simple, and is justified since corporate taxes yield two-thirds of all direct tax revenues. More compellingly, all corporate tax returns were electronically filed in 2008-09, as against 90 per cent for non-corporate firms, and just 13 per cent for individuals.

The document does not generate avoidance percentages from the estimates of absolute revenue foregone. A simple enough step, one might imagine, but not that simple as it turns out.

Corporate returns filed in 2008-09 pertain to the previous year (PY) 2007-08. Data on taxes paid (inclusive of all cesses and surcharges) during 2007-08 show an effective tax rate of 22.24 per cent of profit before taxes. Placed against the statutory tax rate of 33.99 per cent (inclusive of add-ons), this yields an avoidance rate of around one-third.

But if the revenue foregone is applied to corporate tax revenue actually collected in 2007-08, we get a lower avoidance estimate of one-fourth of potential revenue. This is because total corporate tax collections in 2007-08 were Rs 1,92,911 crore, higher than taxes reported as having been paid by the universe of all taxpaying corporate entities during the year, by about Rs 33,000 crore. About half of this was revenue from the Fringe Benefit Tax, and the Dividend Distribution Tax. That leaves an unexplained element of additional revenue amounting to 0.3 per cent of GDP.

If we accept mystification, and place avoidance at 25 per cent of potential revenue, it implies that corporate tax collections, amounting to a little under 4 per cent of GDP in 2008-09, could have ramped up to 5.2 per cent with zero avoidance. Is that where the DTC will get us to? Not quite. Exemptions accounting for around half of revenue presently foregone still remain, in the form of profits in specified sectors listed in the thirteenth schedule, and retention of enhanced capital allowances for accelerated depreciation and scientific research. (There were no appreciable changes in the June revisions in corporate tax exemptions). So, an avoidance rate of around 12.5 per cent will remain, on average.

Even if it had started out with zero avoidance, the tax code could not have stayed that way. Corporate tax history the world over shows that parsimonious exemptions get loosened over time because of the power of corporate lobbies. A Minimum Alternate Tax (MAT) acts as an avoidance cap. The purpose is achieved whether the MAT is based on assets or on book profits. But an asset-based MAT carries some additional advantages over a levy on book profits. It curbs tax evasion by bypassing reported income and going straight to the income-generating base, and carries the efficiency gain of incentivising better returns from assets (but this could be punitive without carry forward). The absence of carry forward in the draft DTC asset-based MAT was a design defect.

The switch back to a book profits base in the June revision seems to have been because the 2 per cent rate of MAT levy, at a corporate tax rate of 25 per cent, placed the minimum expected return at 8 per cent of assets. This could have been addressed by a MAT rate reduction to 1.25 per cent, or lower. The principle was surrendered for a rate, which was unfortunate. And a sectorally varied MAT rate structure is always possible. The only good reason why an asset-based MAT in India may be a bit premature is that any levy which asks for efficiency in the use of assets, requires ease of exit for inefficient manufacturing units. And that is something we still do not have.

Finally, the misalignment between a corporate tax rate of 25 per cent, and the maximum marginal rate on individuals of 30 per cent, is inequitable when dividends are not taxed in the hands of recipients. A Dividend Distribution Tax at 15 per cent is retained in the DTC, but this alters the incentive structure away from dividend payouts, in favour of deferred capital gains, which always receive lenient tax treatment. Alignment between the corporate and individual rate structures addresses the equity issue in a more non-distortionary way.

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