Removing distortions is a taxing challenge!

The issues of a level playing field for manufacturing, of parity between cost structures of imported and locally manufactured items, and the transaction costs of doing business have been much debated. Controversies on whether India is overtaxed assume significance in the context of the forthcoming Budget, as also the professed changes in the paradigm for development being articulated by the present government.

One side of the argument focuses on the low tax-GDP ratio, the low compliance levels, that the reported number of high income-earning peoples is unconscionably low, and that there are distortions in the tax structure due to concessions and exemptions.

The other view is that recent changes in the tax structure, in particular service tax, has increased the indirect tax burden and that the total tax burden on the few who pay taxes is on the increase, making manufacturing less competitive and tax avoidance more prevalent.

There is a general consensus that distortions in the tax structure need correction. It is little understood that several of these distortions arose during the post- 1991 liberalisation era. Initial efforts to rationalise the tax structure focused on reducing customs duties and removing industrial licensing and import barriers. Other countries, in a similar phase of development, adopted the model of reducing customs duties on inputs and capital equipment in the first instance, allowing local industry through direct tax initiatives to invest and grow into a competitive entity. But, the reductions were far more ad hoc here. Interests, both in the private and public sector, ensured that basic intermediates like petrochemicals, steel, copper and aluminum remained protected, and the reduction in across-the-board customs duties intensified competition for the end-product manufactures. The race for mass manufacturing of goods for the global market was lost right then, in the early years of liberalisation.

Simultaneously, the introduction of Cenvat required an upward adjustment in excise duties, so that Modvat credits could be accounted for. A level of 16% was fixed upon, and remains the most common excise duty rate even today. These distortions would perhaps have been corrected later, but the reforms process slowed after 1994, to pick up steam again only in 1998. The first phase also saw distortions introduced in direct taxation, with exemptions for particular activities like software and construction, and a complicated structure of tax incentives and tax relief for exporters.

The post-1999 changes followed a three-pronged policy. On indirect taxes, the effort was to standardise excise duties into a single rate, to provide for and introduce countervailing duties on imported goods, equal to the excise duty charged, and, in general, to clean up the excise processes. On customs duty, it was recognised that the only practical way out of the maze of duty structure inversions was to squeeze the difference between the top and the bottom rates, as much and as quickly as possible. So the top rates kept coming down and still need to come down further.

Aberrations like the SAD were abolished. The process was far from being simple. Aberrations and distortions were introduced on the demands of sections of industry and some arose due to international commitments. It is in the area of direct taxes that the last few years have both simplified and, paradoxically, complicated the process.

Recognising the impact of existing exemptions on the tax-GDP ratio, several partial attempts were made to reduce these. Much more remains to be done. At the same time, distortions were added ? excise concessions for Uttaranchal and Jammu & Kashmir, continuing income tax concessions for the housing industry and extension of time for exporters and the software industry. Most important, service tax became a major measure for mobilising additional revenues. Thus, the ratio of indirect to total taxation, which had been dropping for over a decade, has started increasing ? a retrograde step.

Anxieties over the introduction of Vat have persuaded several states to increase taxes and levies in recent years. If Vat causes buoyancy in revenues, as the proponents are claiming, a substantial amount will come out of the consumers? pockets through additional levies. If we add up all this, a 12.5% Vat at the state level, a 16% excise duty and a 10% service tax, and to top this, a 35% level of corporate taxation, there are strong grounds for the argument that taxation levels are high. If we look at the exemptions available, through duty DEPB and other schemes, excise relief in geographical regions, benefits under dividend and capital gains taxation and deductions allowable under income tax (tax paid by corporate s is close to 20% of profits, not 35%), there is room for arguing that there are many opportunities to improve tax compliance, tax collection, and indeed, tax law.

We are all responsible for the mess ? the articulators, interveners, advisors and policymakers. And clearly, this structure is leading to distortions in development ? regional distortions with industries moving to locations with tax concessions and sectoral distortions with certain sectors unduly advantaged. And tax burden distortions, with those who could pay more, paying much less, and vice-versa. This is evident from the fact that in spite of great corporate performances this year, corporate tax collections are far below budgeted expectations, and total tax collections could fall way below targets.

The challenge is to get the tariff structures right, to remove the burden where it has fallen unfairly and to tax the untaxed. A tall order ? it is very doubtful that this will happen in this Budget.

The writer is a former finance secretary and economic advisor to the PM