Mind that goose

There are demands to increase the tax rate paid by companies. Classical public finance suggests that we should focus on individuals as the tax base. Ultimately, all income lands up in the hands of individuals. The government should have nothing to do with the ways in which individuals organise production — be it proprietorships, partnerships, companies, clubs, NGOs, associations, and so on. To tax the mechanisms of production, over and beyond taxing individuals, is wrong because it gives people incentives to organise production in distorted ways, so as to avoid taxes. These distortions hurt growth; they hinder the growth of the goose that is laying the golden egg.

In India, we have tried to address this problem by removing the double taxation of dividends. This is a laudable quest but a messy solution. For example, mutual funds buy bonds, and pay out interest received from those bonds as “dividends”, and these payments enjoy tax exemption since dividends are tax exempt. The corporate tax framework continues to suffer from a very high depreciation rate, which gives our companies a tax subsidy in favour of capital-intensive production, and disfavours labour-intensive production. The best method to remove double taxation is to eliminate the corporation tax altogether, and only tax individuals. With the new IT systems in tax administration, it is easy to ensure that every bit of dividend paid by companies to individuals is properly tracked, so that personal income tax is paid correctly. This correct solution would get government out of an involvement with how production is organised, and refocus the income tax purely on the financial flows surrounding individuals.

Until this correct solution is implemented, the agenda for reforms consists of unification of the rate for companies and the rate for individuals. If companies are taxed at a higher rate, then companies will have distorted incentives to not show profits, and channel cash flows into the hands of individuals in various ways. The top priority should hence be on unification of the peak rate for individuals and the peak rate for companies. This should be accompanied by bringing the depreciation rate in line with international standards, to a value like 15 per cent. Such a package would increase total tax payments by companies, but avoid distorted incentives in favour of either misrepresentation of cash flows, or a bias against employment generation. The Left probably wants higher tax payments by companies, but they would do well to present more nuanced arguments than the antediluvian advocacy of a higher corporation tax rate.