SEBI and the Reserve Bank want to stop companies and banks from putting their money in mutual funds (MFs). They prefer to invest through MFs because of a tax arbitrage: dividends distributed by debt MFs attract a lower rate of tax as compared to income generated by direct participation in the market.

This tax arbitrage is irrational and must go. The government should scrap dividend distribution tax (DDT) levied on companies and instead tax dividends in the hands of shareholders. The original rationale for a DDT to replace tax on dividends was administrative ease and evasion of tax by a variety of investors.

A practical way out is to mandate electronic crediting of all dividend payments and presumptive deduction of 30% tax at source. This was not possible in 1997 when DDT was first introduced and when bank computerisation was still patchy. Investors who fall in the lower tax brackets of 10% and 20% can claim refunds. Income-tax authorities must, of course, streamline refunds, in tandem.

In effect, dividend income should be taxed according to the individual shareholders tax slab. A change in the tax treatment on dividends will have multiple benefits. It would boost the governments revenues, as promoters, who have been paying themselves hefty, tax-free dividends, pay 30% tax on their income. It would end the tax arbitrage on investments in MFs and, thereby, remove the artificial incentive companies have for carrying out their treasury deployments through MFs.

Similarly, it would remove a large part of the incentive that banks have for lending to one another and to companies via MFs. There would be greater transparency on bank lending. Such a move would, in addition, restore salience to the role of MFs as vehicles for retail investors to invest in securities. And all MFs can have tax pass-through status.

The short point is the superiority and administrative ease of taxing dividends in the hands of shareholders as compared to taxing companies for the dividends they distribute. In the long run, as and when all tax exemptions are removed, and tax revenues rise to required levels, dividends could be exempt from tax altogether.