First principles, first

P. Chidambaram, the Union finance minister, is one of India8217;s best lawyers, and his credentials in terms of knowledge about the tax system are unquestioned. This gives us high hopes about what he might achieve in his budget. The present mess in excise, service tax, sales tax, octroi, and so on, needs to be replaced by a simple value added tax VAT. State governments are said to be moving to a VAT. The finance minister needs to show a clear game plan for how the administration of the national VAT and the state VAT will operate as a single harmonious whole. The central thing that Indian companies need is to deal with a single tax system through a web browser, and to not have to deal with multiple authorities through multiple forms.

On income tax, the central problem is that of exemptions. We have built up a maze of vehicles 8212; like mutual funds and insurance products 8212; through which taxes are dodged. Some of these vehicles, like the employees provident fund, are high cost borrowing for government. There is an urgent need to make a clean sweep of all these, to obtain a simple and rational tax structure. Chidambaram has fumbled on this before. When he was finance minister last time, he cut rates 8212; which was the correct thing to do 8212; but forgot to simultaneously eliminate exemptions. He has had many years to mull over this experience, and we may hope that such mistakes will not be repeated this time.

Finally, there is the need to stick to basics. There are only two taxes which economic logic supports: the VAT and the personal income tax. We should devote ourselves to getting these right. All other tax mobilisation has major flaws. The turnover tax 8212; ie, tax on financial market turnover 8212; is one such element which does not survive scrutiny. We have spent ten years of financial sector reforms trying to obtain frictionless trading on the market. The turnover tax hits in exactly the opposite direction, and serves to undo the good work done in obtaining liquid markets. The international experience shows strongly that the turnover tax is distortionary: it damages liquidity and price formation, and trading shifts to untaxed markets. If the equity spot market is taxed, trading will shift to the equity derivatives. If both are taxed, equity trading will shift offshore, and local markets will shift to trading commodities instead. Every market that is targeted for the turnover tax will have a sharp collapse in liquidity.