Putting at rest months of post-budget gloom, the Indian markets roared back on Friday as the finance minister announced a reduction in corporate income tax. In an unexpected move, the dismissed-as-a-newbie to finance,Nirmala Sitharaman used a smart nudge to get the existing firms to on-board a lower tax regime, while she announced the reduction of the tax rate for new firms. Firms incorporated on or after 1 October 2019, that do not avail any tax break, will now pay 15% (effective rate is 17.01% post surcharge and cess) as corporate income tax, down from the existing top marginal rate of 34.94% for firms of turnover over ₹400 crore.
Older firms, some of whom had been very vocal in the past few months asking for a tax reduction to be globally competitive, will now be faced with a choice: continue to pay at the current rate and avail all exemptions applicable or give up the tax sops and move to a lower tax rate of 22% (25.17% post surcharge and cess). It would be interesting to see how many of the firms that were so publicly traumatized by the high Indian corporate tax rates will migrate to the new lower tax rate. It could be that they were already paying much lower than global standards due to all the tax breaks in the system.
To level the playing field between firms and individuals, and to potentially garner higher taxes, the FM should now extend this option to the individual income tax payers as well. There are three parts to this argument. One, allow all new tax payers to on-board a system with zero exemptions, deductions and rebates (yes, there are three different tax sops in the 4-inch-thick tax primer read by some of us) and pay a lower income tax rate. At the highest slab of incomes over ₹5 crore, the marginal tax rate is as high as 42.74%. A substantially lower marginal rate, for instance, would potentially motivate a swathe of tax payers to begin paying income taxes.
Two, go back to a much simpler slab system. What began as a neat three slab tax rate system, now has seven effective levels due to the surcharges on higher incomes. The creeping rise in tax rates for the rich has come partly because of the political messaging to the mass of Indian poor that this government is not pro rich. But Modi.20 must understand that the suit-boot-ki-sarker jibe has lost its sting and the political mandate to carry out bold economic reform was declared in May 2019. Reducing the tax slabs and reducing taxes for the rich at the top end will not do any lasting damage, but can nudge a higher compliance due to a reasonable tax rate.
Three, give the old tax payers a choice to continue with the complicated system at the current rates or allow them to give up their tax breaks and pay a lower tax rate. Choice is a powerful tool to increase the appetite for difficult decisions, but the choice has to be kept simple or people freeze. The learning from behavioral economics is that people don’t want to make complicated decisions and will prefer a simpler choice set.
There are obvious problems with this idea of a simpler individual tax regime that will need to be worked out. One pushback is on the flow of household savings in general and to desired destinations (like insurance, real estate or provident fund) in particular will fall. I think this is a part of the old mai-baap argument that saw India negotiate the 70s and 80s of the government deciding for the people and the people being not that smart to make rational choices. But in a market where different financial and real products are competing on pure merit and not the tax sop, we may see investors make better choices and firms offer better products. The 70s idea that Indians will not invest unless there is a tax break went out of the window when the systematic investment plans (SIP) book tore through the 8,000 crore a month mark earlier this year. Almost a trillion rupees comes to invest in risk-bearing products through the SIP without getting a tax break and it stays the course despite choppy markets. This is mature investor behavior and the FM should not worry about a dip in household savings due to a change in tax incentives.
The FM should know that the social media eco-system has already decided that this Diwali she will light the income tax fire cracker for the tax-paying Indian individual.
Monika Halan is Consulting Editor at Mint and writes on household finance, policy and regulation.