Direct taxes Code: need for greater Reflection
M Govinda Rao, R Kavita Rao
A new tax code that overhauls the complexities that have emerged in the Income Tax Act of 1961 has been long overdue. The draft Direct Taxes Code put out by the Finance Ministry for discussion and comment does just that in a number of areas. At the same time questions must be posed of the sweeping reduction in rates and restructuring of slabs in income tax, which are likely to rob the exchequer of a significant amount of income. Questions must also be asked of the proposed taxation of not-for-profit organisations.
M Govinda Rao (firstname.lastname@example.org) and R Kavita Rao (email@example.com) are with the National Institute of Public Finance and Policy. Economic & Political Weekly EPW
n the 2009-10 budget speech, Union Finance Minister Pranab Mukherjee promised to build “…a trust based simple, neutral tax system with almost no exemptions and low rates designed to promote voluntary compliance” and towards that end, committed to unveil a Draft Code of Direct Taxes for public discussion. The purpose of the new code is to simplify the enormous complexities in direct taxes since the enactment of Income Tax Act, 1961. As stated by the finance minister, the objective of the new code is, “…to improve the efficiency and equity of our tax system by eliminating distortions in the tax structure, introducing moderate levels of taxation and expanding the tax base”. In fact, periodic redrafting of the code is necessary to update the tax system to conform to emerging economic realities and clean up the complexities it acquires over the years. Income taxes – both individual and corporate – have indeed become extremely complex over the years. The plethora of exemptions and tax preferences to fulfil a variety of objectives has not only eroded the base, it has also complicated the tax system with unintended consequences on resource allocation. The complexities in the Income Tax Act have only made the legal and accountants’ professions very lucrative. The situation has led not only to high administrative and compliance costs but also significant distortions in resource allocation. Not surprisingly, the taxpayers are very enthused at the all-round reduction in the rates, but not on giving up exemptions and preferences. On the whole, the media and businesses have welcomed the draft code on the perception that a significant proportion of the taxpayers – both persons and businesses – will have to pay lower taxes. In fact, virtually everyone is oblivious of the revenue implications, and take it for granted that the expansion in the vol xliv no 37
base proposed in the code will compensate for the revenue loss due to a change in the structure. It was John Maynard Keynes who stated, “Soon or late, it is ideas and not vested interests that are dangerous for good or evil”. But in India, the tax system has been affected more by vested interests than by ideas and eventually, we should not end up with lower rates along with continued exemptions and preferences! This article attempts to evaluate the important changes proposed by the new code.
1 Personal income tax
The attempts to broaden the base by doing away with several exemptions and preferences in the new code are truly welcome and they can help in reworking the strategy towards achieving fiscal consolidation. In general, removal of exemptions and preferences is also important from the point of view of avoiding unintended distortions in the economy, reducing the compliance cost and ensuring greater horizontal equity. The best practice approach to tax reform advocates broadening the base not only to achieve greater neutrality and minimise the influence of vested interests on the tax system but also to raise revenues at lower tax rates. The latter is important, for, the distortions caused by the tax system is roughly equivalent to the square of the tax rate, and the lower the rate, the lower will be the...