While many recommend finance minister Arun Jaitley wait for the report of the Arbind Modi committee before making any changes in the direct tax structure, this would be a mistake for many reasons.
While many recommend finance minister Arun Jaitley wait for the report of the Arbind Modi committee before making any changes in the direct tax structure, this would be a mistake for many reasons. For one, even before the Modi report comes in, the direction of change is pretty much known anyway. Two, with the highest tax buoyancy in a decade—budgeted at 1.34 and likely to be much higher—Jaitley can make sweeping tax reforms, take a bet on compliance and win middle-class votes in the bargain. The best way to go about making the personal income tax construct simpler would be to get rid of as many of the numerous exemptions—Section 80C, 80D, etc—as possible and drop the tax rates. As committees in the past have said, a simple transparent framework would ensure better compliance and boost collections. The YV Reddy committee had observed that the incentives are for gross savings that had led to “round tripping” of savings; this led to a very high implicit cost of borrowing for the exchequer.
Indeed, the current structure is so complicated, there is a lot of room to pay very little tax or none at all. In FY15, salary income—the largest source among individual taxpayers—was shown as nil by a substantial 54% of the 4.1 crore persons who filed tax returns in the year. A flat tax, as some recommend, is a bad idea and, the FM would do well to keep a three-rate structure for now. As such, three rates—10%, 20% and 25%—may be a good idea, with the highest rate kicking in at, say, Rs 50-60 lakh or thereabouts. As this newspaper has argued, the jump from a 5% tax rate to 20%, as is the case now, is a steep one and encourages tax arbitrage; also, today’s highest rate of 30% kicks in way too early, at Rs 10 lakh, even if the effective rate, post exemptions, works out to be lower. Indeed, once the exemptions go, it will be that much harder for a taxpayer to show a lower income to avoid paying taxes.
Many argue that removing exemptions will hurt savings, but this is simply not correct. For the bulk of people, savings are determined by the need to provide for old-age expenses, not by the rate of return they offer. While the returns various products offer determine, to a certain extent, in which products the savings will be kept, there is no reason why the government should direct where people should save by offering different tax treatment for different savings instruments. And, in any case, since the same savings can be put to work whether they are in banks or mutual funds or public provident funds, where is the need for the incentives? One committee, in fact, had observed that the tax incentives for savings, while changing the composition of household savings, had perhaps led to a decline in total savings. While it is tempting to keep exemptions such as those for pension contributions, the government would do well to, instead, make direct contributions to Aadhaar-linked pension products for the poor. Lower tax brackets, along with interest subventions, in any case, will ensure savings in housing will remain attractive.
In the case of corporation taxes, the FM will be hard-pressed to meet his commitment of a 25% rate since, thanks to various sunset clauses, the exemptions will take a few years to be fully phased out. But he would do well to keep in mind that, with lower tax rates in most competing nations, this is an added disadvantage for Indian suppliers. Certainly, he has the tax buoyancy to allow for a 1-2 percentage point cut.