Budget 2017: Cut in effective tax rate to 20% is proper follow-through to demonetisation

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Published: January 25, 2017 5:58 AM

A meaningful reduction in effective corporate tax rate, to around 20%, is the correct follow-through to demonetisation

Which means that not only do old myths get rehashed, but also that new myths get created Which means that not only do old myths get rehashed, but also that new myths get created

The economic experts, also known as glitterati at Budget time, are at it again. Which means that not only do old myths get rehashed, but also that new myths get created. One of the favourite all-time Indian myths is that one must increase tax rates to increase tax revenue—and that the tax rate on Indian corporates is too low. This year, there is a greater urgency to the myths. Assembly elections are due in five major states, including in UP, a 204-million population state. If it were a country, it would be the fifth-largest in the world by population, just ahead of Brazil (201 million) and some 54 million behind Indonesia (258 million).

The stakes are high because of state elections and an (expected) people’s verdict on demonetisation. If the Modi-Jaitley combine were to bring about an economically popular budget (not populist), then the fear among the political opposition is that the Modi-led BJP will run away with all the prizes. Unlike previous Budgets where indirect tax changes were paramount (an excise duty cut for Tweedledum, an excise duty increase for Tweedledee), in Budget 2017, direct tax changes should (will?) reign supreme.

Personal income tax rates were reduced to a three-tier structure (10-20-30%) in 1997. The flat corporate tax rate was reduced to 35% in 1997 and to 30% (where it now stands) in 2005. Perhaps, not coincidentally, both these changes were brought about by P Chidambaram in his role as the then finance minister. The finance ministry, and Budgets, have come forth with additional taxes in the form of surcharges and cesses over the years, but the tax rate has been considered untouchable.

This year there is good reason to hope that the government will change the structure (tax slabs and rates) in a major way. Previously (in joint work with Arvind Virmani, goo.gl/8Yb4ar and goo.gl/bl9CMx), I have discussed the desirability of increasing tax revenues by reducing tax rates. Two options, both with a negative income tax component, were offered—either a flat tax rate of 12%, or a two-tier tax schedule of 10% and 20%.
This article is concerned with what needs to be done with our corporate tax rate structure. The existing reality is a flat tax rate of 30%, and an effective tax rate of 25%. The 5% gap between the stated and effective rate is because of exemptions. How does this effective tax rate compare with other countries, especially our competitors? Very badly. The Indian corporate sector is one of the most heavily taxed in the world. Don’t believe me, but believe every major study done on this subject in the last decade.

In the 2012 study, in National Tax Journal, a major academic journal, Douglas Markle and A Shackelford “Cross Country Comparisons of Corporate Taxes” find that for the two decade period 1988-2009, India had the fifth-highest effective corporate tax (23%) rate. In a 2015 study (The 2014 Global Tax Competitiveness Report), Duanjie Chen and Jack M Mintz aggregate corporate income taxes for 95 countries for every year between 2005 and 2014—India had the 14th-highest corporate tax rate for the manufacturing sector (29.5%).

Every year, the Centre of Business Taxation, Oxford University, aggregates corporate income tax rates across 48 countries. They estimate two indicators of taxation—Effective Average Tax Rates (EATR) & Effective Marginal Tax Rate (EMTR). In 2016, India had the fourth-highest EATR, at 30.8%; the top three are the United States, France and Argentina. India ranks seventh-highest with an EMTR of 22.8%.

One of Modi government’s major goals has been to improve business conditions in India, also known as Ease of Doing Business. For the last two years, our rank has stayed constant at 130.5 (131 and 130 in 2015 and 2016, respectively). The major reason for our rank not changing is the high rate of taxation of the corporate sector. The World Bank estimates that in 2016, Indian corporates will pay a tax rate of 60.6% of corporate profits. This is composed of 21% corporate income tax, 4% dividend distribution tax, 15% social security contributions, 14% central sales tax, etc. How much do our East Asian competitors pay? An average of 35%; our South Asian neighbours pay 38%, Bangladesh corporates pay 35%. India’s rank on tax rates—172 out of 190 countries.

So, stop wondering as to why the investment rate has been steadily going down, and is now close to zero for the corporate sector. Stop wondering and blaming all and sundry as to why the Indian manufacturing sector does not grow, and lags behind practically every major country in the world. Start blaming ourselves, and our penchant (inherited from the socialist Congress) for taxing the rich in order not to have money to pay for the poor—suit boot ki sarkar is what Modi inherited from the Congress.

Finance minister Arun Jaitley had announced that he wanted to move to a 25% corporate tax rate, to be comparable to our East Asian competitors. Let us say that Jaitley removes all exemptions and reduces the corporate tax rate to 25%. If the cess and surcharge stay, then this policy will do nothing to improve India’s competitiveness; the 5% reduction in tax rate will be exactly equal to the exemptions now removed. If the corporate tax rate is reduced to 25%, and cess or surcharge or exemptions are removed, then India’s competitiveness will begin to improve and Make in India slogan will begin to have meaning. If exemptions are to be removed, which they should, then the corporate tax rate should be reduced to 20%. This is compatible with the maximum marginal personal income tax rate of 20%.

If tax rates are brought down, wouldn’t tax revenues decline? No—they will increase, because of increase in tax compliance. If the Modi government believed that reduction in tax rates did not increase tax compliance, then they were entirely wrong in their demonetisation policy. Demonetisation explicitly (and correctly) targeted tax evasion—a meaningful reduction in effective corporate tax rate is the correct follow-through to the logic, and pain, of demonetisation.

I have talked to several individuals about the possibility of significant, not-just-tinkering tax reforms in Budget 2017. As with much else since May 2014, the opinion is divided not along caste lines but around whether you voted for Modi (not BJP) in 2014. The people arguing for bad tax policy (i.e., don’t change effective corporate tax rates) are the same who don’t want Modi to be an economic reformer. If, especially post demonetisation, the corporate tax rate is not reduced, the economy will be hurt, and Modi’s popularity will begin to take a hit. Most important, the economy’s growth rate will begin to falter. This must be what the opponents of meaningful economic reform want.

For obvious reasons, these opponents of economic reform cloak their Trojan horse arguments in terms of helping Modi, i.e., don’t cut tax rates for corporates, because this will confirm in the people’s minds that the Modi government is really suit boot ki sarkar. What will truly damage Modi (and the BJP) is the economic growth not accelerating, if job growth does not begin to happen, if demonetisation pain is not replaced by demonetisation gain.

A necessary political and economic strategy for India’s success is for Modi/Jaitley to do the opposite of what the Nehru-Gandhi Congress has done for the last 70 years, i.e., make a significant cut in the corporate tax rate.

The author is contributing editor, The Financial Express, and senior
India analyst at Observatory Group, a New York-based macro-policy advisory group. Views are personal
Twitter: @surjitbhalla

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