(istockphoto)
(istockphoto)

Opinion | It’s time for a direct tax regime that’s growth-focused and fair

A more efficient direct tax system can create space for a lower and less complicated GST that could boost economy activity

India radically overhauled its indirect tax system more than two years ago with the introduction of the goods and services tax (GST). It now has an opportunity to do the same with the direct tax system. A new framework for direct taxes could also provide space for lower indirect taxes that can boost economic activity.

The task force on the direct tax code (DTC) submitted its final report to finance minister Nirmala Sitharaman earlier this month. That is almost exactly a decade after a draft DTC was released for public debate in August 2009. The proposed new code will replace the Income-tax Act of 1961 that has been mangled beyond repair by frequent revisions.

The original GST design was based on sound economic principles derived from the theory of optimal taxation. Two core principles stand out. First, the tax is, in effect, imposed on final consumption goods rather than intermediate goods. Second, it sought to impose a uniform tax rate on most consumption goods, assuming a fully non-linear income tax is available to the government to maintain equity.

The second principle of a flawless GST was compromised during the complex federal bargain needed to introduce the new indirect tax regime. The flaws in GST version 1.0 have been obvious for some time now, but a growing number of people are now thankfully recognizing the problem. This newspaper had warned in an October 2016 editorial that India was then moving to a flawed GST (bit.ly/2zpYe3w), even though it was superior to the older tax system.

The core principles of the proposed DTC can be gleaned from the September 2018 report by the task force, which is available in the public domain. It says that the direct tax system is designed to improve the efficiency, equity and effectiveness of the tax system. A good tax system thus has to promote rather than hinder economic activity, aid economic equality rather than inequality, and be easy rather than complicated to administer.

Some of the most potent recommendations in the September 2018 report of the task force have to do with capital taxation. In a classic paper published in 1976, Anthony Atkinson and Joseph Stiglitz showed that the optimal tax on capital should be zero, though Stiglitz has of late refuted this result. International experience shows that zero tax on capital is clearly impractical, but there is a good case for lower corporate taxes to bring down the general cost of capital in India.

The task force, too, has argued that the high tax cost on return on equity inhibits private sector investment. Also, the current tax treatment of equity capital versus debt capital has been an incentive for excess leverage. “Our recommendation of sharp reduction in the corporate tax rate has the potential to substantially reduce the tax cost on equity and eliminate the bias in favour of debt. This will enable revival of private sector investment and reduce bankruptcy risk." A lower tax on capital could increase inequality. The task force has sought to counter it with the reintroduction of a wealth tax.

Here is a bit more about the issue of income inequality. Global tax reforms over the past few decades have sought to flatten the marginal tax rate schedules. In other words, there is now a narrower gap between the lowest and top marginal tax rates. However, some strands of optimal tax theory suggest that tax rates should generally be higher in societies with greater income inequality. India’s finance minister has already increased the top marginal tax rate through a surcharge in the July 2019 budget.

One of the most under-appreciated public policy lessons is to be found on page 17 of the September 2018 report submitted by the task force on direct taxes. It is the principle that policymakers have to think of the tax system as a whole, rather than obsessively focus on each part separately. What matters is how it all adds up. This was the fundamental flaw in the GST negotiations. The idea that each tax has to be progressive—that milk and Mercedes cannot be taxed at the same rate—has led to a complicated GST that is now resulting in suboptimal revenue. The government should think of the progressive element of the tax system as a whole.

One issue related to this is the distribution of revenues from income versus consumption taxes. The former tend to be progressive, while the latter tend to be regressive. Before the 1991 reforms, India had an immensely regressive tax system because of the overwhelming dependence on indirect taxes. Direct taxes then contributed less than one-fifth of total tax revenue. That has now changed. The two types of taxes have approximately equal weights in government revenues. Direct taxes have to keep growing in importance as labour and capital incomes rise.

A new DTC will thus be important in a distributional sense as well. Higher direct tax collections can create space for a massive restructuring of the GST—with a maximum three slabs and a far lower standard rate. That will help economic growth, as well as make the tax system more progressive.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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