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The Direct Tax Code is still work-in-progress
September, 03rd 2009

The finance minister has done well to clarify that some of the tax rates and brackets mentioned in the draft Direct Taxes Code are only indicative. In doing so, he has signaled that the government is open to revisiting the rates and slabs, perhaps in response to feedback that the ministry has got.

But the problems go beyond rates and slabs, questions need also to be asked about some of the concepts that have gone into some of the proposals in the Code.

The exercise is welcome in that it introduces simplicity and medium-term stability into the tax system and rates, but the Code should be finalised only after a full discussion with all stake-holders, and the vetting of some of its assumptions.

The proposed income tax rates are too liberal. The threshold for the highest slab of income tax of 25 per cent is Rs 25 lakh. Fewer than a lakh people will fall into this category, or about one in 300 taxpayers.

This seems too skewed a structure, because it means that 99.7 per cent of taxpayers will pay a peak 20 per cent tax, or less. Admittedly, the economist Surjit Bhalla has shown the existence of a missing middle, taxpayers between low and high income categories who seem prone to considerable tax evasion. This would point to the need for some moderation of tax rates.

But the draft Code moves too far, especially since the building of a digital database on financial activities has made it possible to track significant evasive activity.

A minimum alternate tax (Mat) based on assets has its appeal, in that it discourages firms which do not earn a minimum return on their capital employed. But it has the drawback that it ignores the business cycle.

When India needs to invest in long-gestation infrastructure projects, this version of Mat could make such projects unviable. Surely, that is not what is intended.

The wealth tax needs reconsideration. It was withdrawn in the 1980s because it never netted much revenue and had a high nuisance quotient. If the idea has been revived, it is probably because private wealth has shot up in the quarter century since then, and a measure of equity is desirable.

However, it makes sense to treat productive wealth differently from unproductive wealth, and to tax the former only when it is encashed (the principle being that tax should be paid when people want to consume their wealth, not when they use it as productive capital).

It should also be recognised that if the threshold for the tax is wealth of Rs 50 crore, those who might fall into the tax net will probably find ways to avoid paying the tax, by either moving their shareholdings into inter-locking networks of companies, or by de-listing stocks (in case valuation is on the basis of market price, an issue of some uncertainty).

If the tax encourages such undesirable behavior and yields little revenue as a result, it would be as well to not introduce it at all.

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