The government must focus on bridging the gap between the effective tax rate of 21% in manufacturing and the statutory rate of 32%
Going by the mood in the government, fresh tax exemptions to boost industry, especially manufacturing, are likely to be at the core of the first full budget of the NDA government.
While predicting Budget proposals is dicey business, those watching the developments closely do indicate that manufacturing may see a tax holiday or a reduction in tax burden in the FY16 Budget to be presented in Parliament on February 28 by finance minister Arun Jaitley.
The argument given in favour of this is that the contribution of manufacturing in taxes is much higher than its share of GDP—it accounts for about 15% of GDP, and the government wants to take this to 25% to generate more jobs and attain high growth.
However, most tax experts would caution the government against exemptions as a route to achieve this goal.
Distorting the current tax system further will be counterproductive for tax reforms in the country, especially at a time when, globally, there is a move towards cutting exemptions, and experts have advised the finance minister against such a move.
The main objective of bringing in the Direct Taxes Code (DTC) and the Goods and Services Tax (GST) is to get rid of tax exemptions while keeping the tax rates low and expanding the tax base.
Why is this a necessity? To what extent the “tax benefits” introduced by successive governments impacted the tax system can be clearly seen in the finance ministry analysis of revenue foregone based on the corporate tax paid in FY13 by a sample of 6,18,806 entities.
The manufacturing sector accounted for 48.79% of the total profits and 45.89% of the total tax payable that year. The service sector’s share in profits and tax payments were 51.21% and 54.11%, respectively. This may suggest there is a case for a boost to the manufacturing sector, but this shouldn’t be done through more tax giveaways.
In fact, there is no credible information on how much tax benefits help a particular industry grow. The real problem that the government needs to address urgently is bridging the gap between effective tax rates (ETR) and the statutory rate. The finance ministry analysis shows the effective tax rate of the entire sample was 22.44% in FY13 as against 22.85% in FY12, while the statutory tax rate was 32.445%.
Then, the exemptions have also introduced a skew in the tax payments. Companies with profit before tax (PBT) of R500 crore or more, accounted for a total of 61.28% of the total PBT and contributed 57.27% of the total corporate income tax payable.
But their ETR was 20.97%, while the ETR was 26.73% for companies with PBT up to R1 crore.
The finance ministry study points out: “The ratio of total income to PBT is much higher (87.88%) for companies with PBT up to R1 crore than that for the total sample (68.98%). This is also reflected by the average effective tax rate of 26.73%, being much higher for smaller companies. This indicates lesser deviance from PBT in the case of relatively smaller companies as compared to larger companies and that higher tax concessions are being availed of by the larger companies.”
The number of companies showing a loss has gone up from 1,84,653 (37.34% of the sample) in FY12 to 2,50,865 (40.54% of the sample) in FY13.
Then, 3,41,382 companies with average ETR up to 20% accounted for 39.70% of the total PBT, 17.83% of the total taxable income and 15.99% of the total taxes paid. Clearly, a large number of companies (3,41,382 or 55.16%) contributed a disproportionately lower amount in taxes in relation to their profits.
This meant that 33,000 companies contributing 4.19% of the total profits and 9.26% of the total taxes, had an ETR higher than the statutory rate showing that the tax liability across companies is unevenly distributed.
Clearly, the government needs to be cautious in expanding the domain of exemptions in the Budget as the more the tax system deviates from the basic principles of the original Direct Taxes Code (DTC) of “low rates with no exemptions”, the more it will become difficult to usher in serious tax reforms in the country.
Though it is correct that tax benefits for the new investments and re-investments will not add to the revenue foregone, it will no doubt cut into the additional revenue generation possibilities in the coming years besides infusing distortions in the tax system.
So, with the enthusiasm to boost manufacturing, the government should not forget the need to eliminate the gap between the ETRs paid by the companies and the actual applicable rates to the extent possible. The original DTC 2009 model suggested 25% statutory corporate tax rate with no exemptions and that is where it has to go ultimately. But, this will take time.
The sector-specific and area-specific exemptions—the investments in the proposed smart cities like Alwar for setting up new industries appear set to get tax incentives in the budget—no doubt appear an easy way to attract companies to invest, but a better strategy to do this for now would be to focus on easing the problems of the industry on more critical fronts like land acquisition, environmental and forest clearances and labour laws.
The NDA government has done its bit, but the changes in the laws are stuck in Parliament because of its lack of majority in the Rajya Sabha.
For any significant push to the industry, it will have to find ways to get the laws cleared in Parliament and not load the Budget with something that it is incapable of doing.