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Thursday, December 02, 2021

Maximise revenue, minimise tax

India has just one policy option to advance private investment and become a $5 trillion economy — reduce corporate tax rate for all firms to 22 per cent, reduce misguided rates of personal income tax.

Written by Surjit S Bhalla , Karan Bhasin |
Updated: July 13, 2019 4:56:40 am
Illustration: Suvajit Dey

Budget 2019-20 contained major tax changes to direct taxes, both personal and corporate. It may have been the last time that we witnessed such changes. Very likely, when Budget 2020-21 is presented, the government would have accepted the direct tax code report, and direct taxes will go the way of excise taxes — out of the budget.

The budget reduced the corporate tax rate (CTR) from 30 per cent to 25 per cent for all firms with a turnover of Rs 400 crore. Earlier, the 25 per cent slab was applicable for firms with a turnover of Rs 250 crore. The FM stated that this move would cover 99.3 per cent of all firms in India. However, it is unclear as to how much of the total corporate taxes is accounted for by these 99.3 per cent of firms. Speculation abounds – is it as low as 10 per cent? We do not know.

Tax rates are always an item of discussion and debate, and now more so than ever. President Donald Trump lowered the CTR for the US from 35 per cent to 21 per cent in 2018. As shown below, the lower tax rate was well chosen by Trump because that is close to the optimal tax rate. But that is getting ahead of the story.

OECD has recently released a comprehensive set of data on corporate taxes, for close to a 100 economies. [ Index.aspx?DataSetCode=RS_GBL]. The data reveals what has been feared (and argued) for a long time — India has one of the highest (actually the highest) corporate tax rate in the world. And, according to OECD, it also has the highest effective corporate tax rate (ECTR) — and that to by a huge margin. India’s ECTR is estimated by OECD at 44 per cent. Their definition includes all taxes paid by corporates in different countries — for example, corporate tax, dividend tax, capital gains tax. Incidentally, the second-highest ETR is for Argentina and it is 9 ppt (percentage points) lower than India, and third is France, 11 ppt lower. China’s ECTR is 20 ppt lower than India at 23.6 per cent! One reason why China has got all the investments, and growth, at least relative to India?

In this age of globalisation, no country is an island. Competitiveness is affected by tax rates, interest rates, exchange rates, and labour costs. However, gone are the days when countries could devalue their way to prosperity. China accomplished this via massive undervaluation for about 20 years, from 1990-2010. Their success ensured that such undervaluation (read currency manipulation) would never again be allowed by the Western powers. It is likely that Trump’s trade war would not have occurred if China had been more responsible with the setting of its exchange rate.

What can countries do to improve their competitiveness, given that the mercantilist route is no longer an option? They can reduce its cost of capital, make labour more competitive, make industry more competitive, and rekindle animal spirits. On the first three counts, the budget has moved in the right direction. Sovereign bond borrowing is an idea whose time has definitely come, notwithstanding the perennial naysayers and those not comprehending the fundamental nature of change in the world. Inflation nowhere (including India) is the bogey it once was. Also naysayers should note, and answer the following question — between fiscal years 2004 and 2011 (the so-called Golden Age of Indian growth) the real repo rate averaged minus 1 per cent. For the fiscal years 2016-2018 real repo rates averaged 2.3 per cent. Go figure the growth implications.

Since Shaktikanta Das assumed governorship of the RBI, there has been considerable improvement in communication and a gradual lowering of policy rates, but this has also been accompanied by a more than equal lowering of inflation, that is, the real repo rate has yet to move below 2.3 per cent. The sovereign bond issue will help, but don’t look for a quick acceleration in GDP growth.

Exchange rate change is no longer operational, labour codes are too slow to change, and monetary policy is sluggish in its operation, and impact. The only real growth option for Indian policymakers — cut tax rates to internationally competitive levels. And what might that be? Around 22 per cent for all firms, and we obtain that result from a comparative study (see below — and chart).

But first, a comment on the personal income tax (PIT) rate increase in the budget. The move to increase PIT rates to developed country levels is not in the right direction. It seems that there was more old-fashioned morality (tax the rich) than revenue maximisation at play. At best, the government plans to raise Rs 5,000 crore more by socking it to the rich. (Total personal income tax collection is budgeted at Rs 5,00,000 crore). And even that may not happen as tax arbitrage between the much lower corporate tax rate and the near highest individual income tax rate (only 10 per cent of countries have a higher than 43 per cent top PIT rate) will move animal spirits towards payment of corporate tax. And if not tax arbitrage, tax evasion may lower gain in PIT collection.

Ostensibly, tax rates are set to maximise tax revenue — and tax revenue depends on both income and tax compliance. Tax compliance can either be considered as more firms filing taxes or more firms revealing a closer approximation to true income. Improving compliance alone can ensure greater resource mobilisation through taxation — and without increasing the tax rate (and may indeed occur if the tax rate is reduced).

The non-linear relationship between tax rate and tax revenue (as per cent of GDP) is revealed by the famous Laffer curve – with zero tax rates, you get zero tax revenue and with 100 per cent tax rate, you get zero tax revenue. In-between, logically, the share of tax revenue increases, before peaking and declining toward zero. Several “truths” become evident from even a cursory glance at the chart. First, that OECD cross-country data for 2017 conforms (fits) the inverted U-shaped curve rather well — and the inverted U is a close approximation to a normal distribution (red line in chart). Second, that the lowest bang for the tax buck is obtained in India, possibly because tax rates are set on the basis of morality rather than revenue maximisation. In India, we tax at 44 per cent to get 3.5 per cent of tax revenue (as percentage of GDP). Both Korea and Israel (and other countries) obtain this same amount of revenue with half of India’s taxation levels. As the chart shows, the tax rate level at which revenue is maximised is around 23 per cent — half India’s tax level.

Why is the effective tax rate in India so high? In India, firms must pay a corporate tax, which is followed by a

surcharge and an additional 15 per cent dividend distribution tax (DDT). The revenue mobilisation from DDT is marginal compared to the overall tax revenue from corporate taxes. Estimates suggest that the resource mobilisation from DDT is just around 8 per cent of the total corporate tax revenue. A steep 15 per cent DDT only dissuades firms from issuing dividends to their shareholders. Forget about double taxation as there’s another moral Indian tax icing — if an individual earns more than Rs 10 lakh of dividend income, she must pay an additional 10 per cent tax. So the same income is taxed thrice in India — and only in India.

Both the budget and the Economic Survey focused on revival of private investment to ensure sustained long-term growth. Thus, there is strong case for further and aggressive reduction in tax rates on the grounds of revival of investment, and helping India become a $5 trillion economy. With another budget just six months down the line, there is hope that the government will realise its mistake and depart from misguided taxation policies.

Bhalla is contributing editor, The Indian Express. Bhasin is a New Delhi-based policy researcher. Views are personal

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