The onset of December is the time for the scents of Budget making to waft through South Block. The adviser to the finance minister has indicated that he is for lower marginal income tax rates. Five years ago, when he was heading a committee in the Planning Commission to examine rationalization of income tax, he had strongly suggested doing away with a number of exemptions, and rationalizing tax rates at a lower level. Governments since then have been moving in this direction, but not fast enough.
This year may be an important opportunity to have a fundamental look at taxes, both direct and indirect. There are several reasons for this. First, tax revenues have shown a healthy growth. Corporate taxes have been particularly buoyant. Tax-GDP ratio has been on the rise for the last four years, and is approaching emerging economy averages. Revenues of the states have been growing as well, bolstered by the restructuring of state loans and the smooth implementation of the value-added tax (VAT). Several states have revenue surpluses this year, and the growth in liquor excise revenues has been staggering.
Second, the new finance commission would definitely recommend some additional devolution, and this, coupled with the growths in VAT revenues and excise growth (growing GDP per capita would surely lead to greater consumption of branded alcohol), is likely to make state finances comfortable for the next five years.
Third, the urgency for tariff reforms arises from several distortions that have crept in during the last few years. For example, customs collections (of which around 70% are accounted for by petroleum and petroleum products) are growing much slower than import growth. Excise collections do not reflect the increases in industrial production. Either there are significant leakages or there are a large number of exemptions, including area exemptions for special economic zones and special areas such as Uttarakhand and Himachal Pradesh. It is time to take a look at these.
It is also time to revisit the question whether there cannot be a convergence between personal income tax rates and corporate rates, shorn of all exemptions.
In my view, the first area of focus should be indirect taxes, where government is not getting the bang for the buck. There are only around 500,000 organizations in the country that are subject to Central excise, and less than 100,000 of these account for more than 70% of the collection. Given the pressure for exemptions, which clearly creates a distorted excise map, a clear road map to reduce excise duties could be considered. A 2% reduction would leave excise revenues largely unaffected. This is because in the present Modvat structure, firms are paying only the difference between the excise paid at the earlier intermediate level and the present level, and often excise payments at the last stage get crowded out. This feature would contribute to revenue buoyancy in the reduced tariff regime. This move would also help in setting the levels for the Central GST at reasonable levels in 2010.
The second area is customs duties. There is a view that unilateral reduction of customs tariffs dilutes bargaining positions at the World Trade Organization negotiations. Whatever the merits of this argument, there is little justification in maintaining a slew of exemptions and inverted tariff structures, where raw material tariffs are higher than those for finished goods. The large number of preferential trade agreements under negotiation is also likely to distort import tariffs. I am as concerned about the customs department’s ability to deal fairly with a multiplicity of regimes, as with the need for such multiplicity. A simple structure with a flat rate of 5% and 10%, and countervailing duty to protect local manufacture, could clean up most of the act.
But I am certain that all this does not interest the general reader: Only income tax does. There is an opportunity for this year to raise the lower floor substantially—even if the inflation of the last five years is taken into account, the lowest slab should now start at Rs250,000. The top rates have too many add-ons. A simple tariff of 30% would be comparable to many other similar economies. The corporate rates could also be brought down to this level. This is also an opportunity to encourage long-term savings, in new instruments that could be used for building infrastructure; a 10-15 year savings bond, tax exempt, which could be traded in the exchanges, would find a large number of takers, improve savings rates, and provide funds for infrastructure.
The indirect tax changes are election neutral, and the direct tax changes likely to be welcomed. This is likely to be a populist Budget, and the populism can be focused on the expenditure side, and the opportunity of tariff reforms seized.
S. Narayan is a former finance secretary and economic adviser to the prime minister. We welcome your comments at firstname.lastname@example.org