November 25, 2002
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Money > Special November 25, 2002 |
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The release of the reports of the task forces on direct and indirect taxes and the subsequent furore over their recommendations provide ample illustration of the essential reformist dilemma. Subject the recommendations to any test based on benchmarks of taxpayer friendliness, administrative simplicity or economic logic and they pass. The reactions to them, however, overwhelmingly negative, suggest that a lot of people who have made financial commitments on the basis of the existing regime feel that they would lose enormously in the transition. The surgery will be successful but the patient may well be dead. Let's face some stark realities about our tax system. It has been subject to a decade of reform through rationalisation of rates and, to a lesser degree, widening of the base. No doubt, many of the rate rationalisations, particularly on the indirect tax front, were part of a broader reform agenda for industry and trade and need to be judged from this perspective. However, from the narrower viewpoint of revenue generation, there is little question that, as we stand today, there is a huge disparity between what we expect the government to do, how well we expect them to do it and what we end up paying for it. In my view, the root of the problem is the enormous imbalance in the sectoral distribution of the tax liability. It is, to put it simply, highly industry-centric. Virtually all indirect taxes, more than 70 per cent of central revenues and an equally significant amount for the states, come from industrial products. Corporate income taxes are not so discriminatory because all companies are liable, but here again, corporate presence in industry (as opposed to services) is high, relative to its share of GDP. Indirect taxes on services, both the largest and fastest growing sector, are negligible. Agriculture, of course, with its combination of procurement, fertiliser and power subsidies, is a net absorber of fiscal resources. I am not advocating any mechanical rule that requires net tax contributions to be proportionate to share of GDP. Growth and equity considerations should unquestionably play a role in tax policy and may well justify a skewing of the load away from, for instance, agriculture. However, even with all these considerations in mind, it is difficult to accept the degree of the skew towards industry; more so, when this sector has been in the doldrums for some time. Despite a mild recovery this year, and there is little to suggest a significant improvement in long-term prospects. Against this background, it is easy enough to understand the vehement reactions of industry to many of the recommendations on the direct tax front. Given the overall business climate, the tax exemptions apparently make the difference between a project being or not being undertaken. From a theoretical perspective, except in situations in which there is a clear justification based on the larger public good, this is a highly undesirable state of affairs. Unfortunately, however, tax exemptions appear to be the only remaining tonic for an enervated, listless industrial sector. This leads to another dilemma on the part of the reformers. Should they work on a business-as-usual assumption, in which industry chugs along, but does not accelerate significantly, or should they buy into the official optimism about future growth? As a research exercise, of course, there is no reason why both can't be done, but the tax reform blueprint will critically depend on which one they are more inclined towards. The task force recommendations on direct taxes, to my mind, are geared towards an optimistic industrial growth scenario. This is a scenario in which returns to investment are high enough not to be significantly influenced one way or another by tax rates. Thus, if an investor is not going to be induced to put up his project solely by an exemption, why have the exemption at all? It has no economic impact and its elimination automatically leads to an expansion of the tax base. Similarly, from the individual tax perspective, why induce him to save in instruments that merely finance government consumption expenditure when you really want him to be financing investment spending, which is yielding decent returns in any case? If rapid growth leads to large increases in employment and income mobility, there is also a revenue justification raising the exemption limit. Servicing very large numbers of very small accounts is highly cost-ineffective. Just ask the public sector banks. It needs a certain minimum amount of tax paid to make an account worthwhile. As long as enough people are crossing the threshold each year, you can afford to keep it relatively high. Similarly, on the elimination of the exemption for interest on housing loans, it may have made sense when interest rates were 15-16 per cent, but surely, at today's rates, the tax exemption would be, at best, a marginal influence on anybody's decision? To put it in more general terms, exemptions are fundamentally iniquitous, because they favour the small number of people who pay taxes and, in effect, penalise the large number who don't, but who still make the same savings and investment decisions. In a buoyant economy, when such decisions are being made on the basis of real returns, to the extent that tax exemptions have no more than a marginal impact, they only serve to narrow the base, which goes against the whole purpose of tax reform. Conversely, the opposition to the recommendations is essentially based on a relatively pessimistic view of economic prospects. Returns on investment are weak and need to be boosted by exemptions. Individuals' expectations of returns from their equity portfolios are low. They want both safety and high returns. Tax exemptions, particularly in a falling interest rate environment, tend to sweeten the deal. On the basis of economic pessimism, these are probably legitimate demands for the moment. However, taking a somewhat longer view, a combination of a stagnating economy and a distortionary and ineffective tax regime is a crisis waiting to happen. The critical issue, then, is the things that are likely to happen that will foster an environment in which the tax reform recommendations are rooted. Several years after the realisation that half-baked reforms are no solution at all, we are still waiting for the oven to be turned on again. However, if the growth momentum were to resume, the broad thrust of the direct tax recommendations is far more likely to reinforce it than to impede it. They do not directly address the more fundamental issue of sectoral imbalance, but that is a far bigger issue that needs more time and thinking. Powered by ALSO READ:
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