The second version of the draft Direct Taxes Code (DTC) released last week was summarized by most newspapers, business as well as general news dailies, with a single word: dilution. Herein lies the political economy of the proposed direct tax reform, besides offering valuable insights into the thinking of the new leadership in the finance ministry in managing change. As opposed to the big-bang style, the new approach to direct tax reform seems to be consensus-based.
DTC had been billed as the final effort to overhaul the current tax regime and bring it on par with the new-look Indian economy. At the centre of the proposed change was a move to a simple and transparent tax structure that will allow for few (or ideally no) exemptions; a broader tax base would enable lower tax rates and, thereby, better compliance—the incentive for tax avoidance is consummately lesser.
The first version largely stayed within this paradigm. It offered the carrot of lower rates, but was uncompromising when it came to targeting exemptions. However, its introduction in the public domain triggered a campaign, particularly by industry groups, to dilute some of the provisions, particularly those governing exemptions. In all, some 1,600 representations were received by the finance ministry. The outcome, as Mint reported after the second draft was released on 15 June, seemed to match the expectations of the lobby groups. Consequently, the momentum of tax reform has definitely been disrupted.
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At first glance, particularly with respect to changes affecting corporate India, it does indeed suggest dilution of the first draft. At the same time though, it does offer some interesting perspectives on this finance ministry’s approach to direct tax reform.
First off, the political leadership differed between both drafts. P. Chidambaram (at present the home minister) oversaw the first draft, while Pranab Mukherjee presided over the latest version. While the former has an established preference for big-bang reforms (remember the “dream budget” of 1997?), the latter is known for his penchant for managing consensus (precisely the reason why he is probably the head of the largest number of ministerial groupings ever). The dilution in the draft reflects these different approaches. For some reason, Mukherjee has preferred an incremental approach, resulting in what most tax analysts argue means sticking to the existing tax regime.
Secondly, a bulk of the concessions (from the first draft), for whatever reasons, seems to benefit existing companies and big corporate families. Some of this flies in the face of the very facts/logic that the finance ministry put out earlier this year during the presentation of the Union Budget 2010-11; more of this later.
The main rejigs in the new draft include: reverting to the existing method of determining the minimum alternate tax (MAT) by dropping the provision to estimate them on gross assets and instead stick to the current practice of using book profits; reversing the changes proposed in the first draft that would have allowed the changed domestic law to override tax treaties (such as the tax avoidance treaty with Mauritius) and, thereby, bringing investments routed through these countries under the tax scanner; and financial assets such as securities would not be included while assessing wealth tax in the transfer of assets between generations (The first draft had proposed a levy of 0.25% on wealth in excess of Rs50 crore, including financial assets, of an individual or a Hindu undivided family).
These and other concessions seem to challenge the implicit logic—the tax equity principle—spelt out by the accompanying documents of the Union Budget. The effective tax rate, computed by the ministry on the basis of 90% of the corporate returns, for companies was 22.78%—not only less than the statutory 33.99% in 2008-09, but even less than what some salaried individuals pay. Worse, 55,989 companies had an effective tax rate less than 20%; while they account for nearly 43% of the profits earned by the total sample size of 366,000 companies, their share of total taxes was only one-fifth. Outlining this, the receipts budget for 2010-11 then goes on to state unambiguously, “The tax liability across companies is unevenly distributed. This is primarily due to the various tax preferences (read exemptions) in the statute.”
In essence, the latest draft DTC has retained a lot of exemptions, or at least “grandfathered” (retaining them for a limited period) them. It makes it difficult to push for lower tax rates as this was predicated on the withdrawal of exemptions, implying that the gap between the statutory and effective rates will be retained. This is seemingly unfair since it will benefit existing entrepreneurs; all the more since several exemptions have been grandfathered—they won’t exist in the future, thereby relatively disadvantaging future entrepreneurs. Instead, it would make better sense to have a statutory lower rate rather than facilitate it effectively through exemptions.
The debate will now move to Parliament, with the government proposing to introduce it as a new law in the monsoon session, where most certainly the politics of the latest draft DTC are bound to kick in. On this, the Congress-led United Progressive Alliance may find itself on the defensive as clever politicians in the opposition are bound to contrast the ruling coalition’s overwhelmingly pro-aam aadmi (common man) image with implicit actions in DTC.
Anil Padmanabhan is a deputy managing editor of Mint and writes every week on the intersection of politics and economics. Comments are welcome at email@example.com