But reduce exemptions too

Finance minister Chidambaram says he will consider a reduction in direct tax rates provided voluntary tax compliance keeps improving. The latest data suggest that direct tax collections have risen by a whopping 42% in April-November 2007, higher than even the record 39.27% improvement in 2006-07.

Clearly, tax compliance is improving. The next Pay Commission award is expected in a few months and will increase the central wage bill hugely. Hence caution is warranted in lowering tax rates. But a plan must be chalked out to make India’s corporate tax rate competitive.

Historically, corporate tax rates were not viewed as determining the competitive advantage of nations, but the success of low-tax countries ranging from Singapore and Hong King in Asia to Ireland and Estonia in Europe has proved otherwise. French President Sarkozy has pledged to slash his country’s corporate tax rate to 25%, Germany is down to 29.8%, and Scandinavian countries to 28%. The Asia-Pacific average is 30%. Rates are lower in Malaysia (27%), Taiwan (25%), Singapore (18%) and Hong Kong (17.5%).

India’s base corporate rate is currently 30%, on par with the Asia-Pacific average. But surcharge and cess raise the Indian rate to 33.9%. Indian corporates also pay dividend tax, which in other countries is borne by individuals. Finally, Indian companies also pay fringe benefit tax and securities transactions tax. So, the total burden is around 35% for many corporates.

This looks steep. Yet the finance ministry is quick to point out that, because of many exemptions and exceptions, the effective rate of corporate tax is only 19%. Some of the companies in sectors with the highest profit margins such as software pay no tax at all, while old industries like textiles with low profitability pay the highest rates. New industries in Uttarakhand and Himachal Pradesh get tax exemption for years.

This makes no sense in terms of natural justice or tax logic. So, tax reform should aim at lower rates along with fewer exemptions. For instance, tax exemptions for software parks and export-oriented units should be phased out on schedule in 2009, and region-specific exemptions should not be extended either. This reform is required over and above cuts made feasible by better compliance.