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Alok Ray

The plethora of exemptions and deductions has made the tax system highly complicated. Though most economists agree on abolishing the deductions, they do not on doubling the exemption limit, fearing that a vast mass of lower-end income assessees would go out of the tax net. So, a compromise package — which would address both the economic and the political compulsions — may be tried, says Alok Ray.

TRYING to predict the Budget is always hazardous. Nonetheless, it is done as people are inherently impatient. They are willing to go even for tarot cards to know what would happen in the World Cup cricket match taking place within the next one hour. So, what guesses can we hazard about the coming Budget?

A few predictions can be made as fairly probable, despite what the Kelkar Task Force may have recommended.

For example, no agricultural income tax is going to be introduced as it is a political minefield. Similarly, no major changes would be introduced to abolish the standard deduction and the various other deductions and exemptions allowed at present, especially with elections round the corner in several states. However, some small beginnings may well be made to indicate the intended direction of changes without toppling the political applecart.

Why is the gradual elimination of the exemptions/deductions necessary? The plethora of exemptions and deductions has made the tax system highly complicated. Moreover, it may be inequitable.

For instance, suppose Mr X's wife earns some money by private tuition or from inheritance. But she is not a taxpayer since her total income is below the exemption limit. Mr X can reduce his tax burden by partly meeting his household expenditure from his wife's income and investing his own savings in National Savings Certificate (NSC).

Mr Y has exactly the same income and expenditure as Mr X but Mr Y's wife has no income. In that case, Y will have less savings and hence higher tax burden. Y is doubly cursed — his total family income is less but he ends up paying more taxes. Clearly, the system favours people already better placed in life. One oft-mentioned argument for retaining these deductions is that they promote savings. But empirical evidence suggests that they mainly affect the composition rather than the total volume of savings. If one saves tax by investing in NSC but no such saving from bank fixed deposits, he would put less money in bank and more in NSC.

The tax saving bonds such as the RBI bonds carry a tax-free interest of 8 per cent. With a 30 per cent marginal income tax rate, this is equivalent to more than 11 per cent interest on bonds or fixed deposits whose interest is not tax-free. This would mean that people would put more money in the tax-saving bonds unless the interest on bank fixed deposits is comparably high.

Thus, the tax-saving bonds are putting an upward pressure on the overall interest rate structure when the Government is trying to bring down interest rates. The cost to the government of raising funds through RBI tax-saving bonds is correspondingly more than 11 per cent, as it has to take into account the implied tax revenue loss. This is yet another argument for abolishing the tax savings allowed on investment in some designated schemes.

Though most economists (but certainly not tax-payers or consultants) agree on abolishing the deductions, they do not agree on doubling the exemption limit from the current Rs 50,000 to Rs 1 lakh at one go, as the Kelkar report has suggested.

The apprehension is that a vast mass of lower-end income tax assesses (about 40 per cent of taxpayers) would go out of the tax net. Some of them would have graduated to higher tax brackets later.

They also point out that our exemption limit is not particularly low by international standards. So, a compromise package — which would address both the economic and the political compulsions — may be tried. Namely, raise the exemption limit by some Rs 10,000 to 20,000 which would sell the Budget as `pro-poor'.

At the same time, Section 88 deductions for investments in designed savings schemes may be brought down a little for people earning, say, between Rs 2 lakhs and Rs 5 lakhs (who may be labelled `middle class') to balance the revenue loss.

Remember, no standard deduction or Section 88 deductions are currently allowed to people earning more than Rs 5 lakhs annually ( the `rich') in any case. Another strong possibility is the abolition of dividend tax. What are the pros and cons here?

A standard argument against dividend tax is that it involves double-taxation. The company first pays tax on the pre-tax profits and the same income is taxed again when the person receiving the dividend has to pay the dividend tax. But this is not a water-tight argument.

The same rupee is taxed twice when a person pays income-tax on his salary and then pays sales tax on purchases made with his after-tax income. The double-taxation argument should apply here too and it is not restricted to only dividend income. That is why the double-taxation argument notwithstanding, some Scandinavian countries have dividend tax, while others (US is the most recent addition to the list) do not.

In the current Indian context, an additional argument is being used. In the prevailing recessionary conditions, it is argued that the abolition of dividend tax would attract investment in the stock market and would help economic recovery.

With higher post-tax returns on investment in company shares, people may, indeed, invest more in stocks and less in bank deposits. But this does not necessarily mean that more funds will go into new stocks.

More investment in secondary stock markets does not guarantee new investment in industrial capacity or fuller utilisation of existing capacity. Businessmen would invest in new capacity creation only if they expect a significant rise in demand for their products.

Hence, generation of demand from consumers for consumer goods or from business people for machinery and capital goods is necessary. Abolition of dividend tax may not help either of these under the prevailing excess capacity situation.

A few years back, the former Finance Minister, Mr P. Chidambaram, abolished dividend tax in the hands of the investor. His argument was basically administrative simplicity. He enacted a uniform 10 per cent tax deduction from the companies on dividend distribution but no tax on dividend in the hands of the investors.

This would save the investors (specially the small ones) the hassle of getting tax refunds in many cases. Moreover, it would plug tax evasion by investors by basically having tax deducted at source from the companies.

Mr Yashwant Sinha reversed this by arguing that it is inequitable. Why should a rich investor pay the same 10 per cent uniform tax on dividend income, especially when many salary earners are paying 30 per cent marginal tax on salary income.

So, administrative simplicity was sacrificed for equity and presumably higher revenue collection, though the exact calculations were never made very clear. In the Budget an about-turn towards the Chidambaram days would probably be made, especially since the Kelkar report has also suggested this and it is politically palatable.

The salaried people in India have a lingering grudge, irrespective of the tax rates or the status of exemptions. They feel that the burden of direct taxes falls almost solely on them, while those earning much more do not pay any income-tax. Factually, this is not exactly true. Only 35 per cent of personal tax revenues are contributed by the salaried taxpayers while the rest is contributed by the self-employed.

Even then, there is a big element of truth in what the salaried people complain about. It is often the case that fairly rich self-employed doctors and lawyers (not to speak of politicians and film heroes) can and do hide a lot of their income. They declare only a small part of their true income in their returns and pay taxes only on that portion. The salaried people cannot do it simply because for them the taxes are deducted at source and there is no way by which they can underreport their salary income.

Another reason for popular dissatisfaction and reluctance to pay taxes is the abysmal quality of public goods supplied by the Government. In principle, taxes are a compulsory payment for public goods.

The state of our roads, government schools and public hospitals makes a taxpayer wonder why he is paying the taxes. Unless some noticeable improvement in the quality and delivery of public services can be made, the moral basis for asking people to pay taxes continues to remain weak. It is a sad commentary on our political and administrative system after 55 years of Independence.

(The author is Professor of Economics, IIM Calcutta.)

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