In fact: The challenge of inequity, the perils of taxing dividends

An internal assessment by the Revenue Department had shown thousands of crores going to investors annually — a good number of them the promoters of large companies, and high net worth individuals.

In his Budget speech on February 28, 2002, Sinha said there was an inherent inequity in a system that allowed those in high-income groups to be taxed at lower rates than what was applicable to them. “These issues have been troubling me over the past four years and I am now convinced that the existing system must go,” he said. He proposed the abolition of the 10% dividend distribution tax on companies and mutual funds, and instead made it taxable at source when it was received by individual investors at 10% — leading to a furore.

The Minister and his team had probably not anticipated the fallout. A day or two after the Budget, some of India’s top promoters, including some of the most respected names now known for wealth creation in the field of software services, landed up at the Ministry to protest the move. Revenue Secretary Narayan, however, was of the view that the argument of those batting against taxing dividends received by individual shareholders was flawed. His line: If a company and a promoter were treated as two separate entities, then the responsibility of handling the liabilities too should rest with the promoter, and benefits couldn’t be treated as tax-exempt. But a powerful lobby managed to keep up the portrayal of the move as amounting to double taxation.

By end-June 2002, Sinha received a call from Prime Minister Atal Bihari Vajpayee who told him that although he (Sinha) was doing well, the public perception was different — and that the Finance Minister should move across the road from North Block to South Block as External Affairs Minister. At a farewell gathering in the conference room of the Finance Ministry, Sinha told his officers that there would now be more of economics in the new ministry (MEA) and more of diplomacy in the Finance Ministry (where External Affairs Minister Jaswant Singh was coming)! Sinha reckons that the dividend tax proposal led to his exit from Finance — in a way reflecting the clout of top Indian promoters and corporates.

And that seemed to be reflected in Budget 2003-04. Singh scrapped his predecessor’s proposal to tax dividends in the hands of shareholders, and re-introduced the dividend distribution tax at 12.5%, leading to great cheer. After that, with growth accelerating and stock markets heading north during 2004-08, moolah in the form of tax-free dividend income was great for lakhs of investors. Foreign banks and wealth managers started to make a beeline for these investors to handle their dividend income. The trend continued — and according to rough estimates from fund managers, in Chennai alone, for instance, the amount up for grabs annually is Rs 5,000 crore now. In Mumbai, it is in multiples of this — with the average annual dividend income of some of India’s top promoters being well over Rs 500 crore and, in a couple of cases, it is well over Rs 1,000 crore annually as tax-free dividend income. No wonder very few figure in the list of top taxpayers!

Subsequently, suggestions to impose a tax on individuals receiving dividends after a certain cut-off — say, Rs 1 crore or so — too were rejected. As were pointers that the US does tax dividends. In a fortnight, Finance Minister Arun Jaitley could announce the first step in a planned reduction in corporate tax, to be rolled out over the next couple of years. Whether this cut will go hand in hand with a chopping of tax exemptions that corporates enjoy remains to be seen. But as the economist Thomas Piketty said in India a month ago, India has one of the worst inequalities in income and wealth globally — Piketty wanted the Indian elite to learn both from history and from the mistakes of their peers elsewhere. That is a challenge not just for them, but also for Indian policymakers.