Three bad taxes and some remedies

Between July 2004 and May 2005, the United Progressive Alliance government has presented and enacted two Union Budgets.

Regrettably, the "dream team" of Manmohan Singh, P Chidambaram and Montek Ahluwalia, have, in the process, introduced three rank bad taxes and somewhat derailed the train of modern Indian tax reform flagged off by V P Singh in 1985.

I should probably let Montek off the hook since, in our Budget process, the Planning Commission plays no role in budget tax policy. But, as all well-informed people know, the Prime Minister and finance minister are the two most important architects of tax policy innovations introduced through Budgets. So the buck stops with them.

In some ways this is particularly disheartening for tax reformers since both the present incumbents have (or had?) considerable reputations as tax reformers, especially Manmohan Singh (of 1991-96 vintage). The three new taxes I am referring to are, of course, the securities transaction tax, the fringe benefit tax and the banking cash transactions tax. The first was introduced in 2004 and the latter two in 2005.

Before I say a few words about each of these unfortunate tax experiments and what should now be done with them, I should note that they run counter to some of major themes of our tax reforms in the last two decades, dominated by V P Singh in the 1980s and Manmohan Singh in the 1990s (at some risk of over-simplification - and misinterpretation - you could call them two decades of Singh-Singh tax reforms!).

These themes include: a thrust towards greater simplicity and transparency in the tax structure; a shift towards taxing value added instead of turnover; the reduction of complex tax rules pregnant with the possibility of discretionary abuse; and a striving for greater equity in the tax structure and its incidence.

To a greater or lesser extent, each of the three new taxes goes against the grain of these broad and good themes.

The STT of 2004 is a turnover tax on financial transactions, introduced (incongruously) at a time when taxation of value added is replacing turnover taxes in central and state taxation of commodities.

Not only does it run counter to the general movement towards value-added taxes but it also breaches the public finance canon against taxing financial transactions (and thus mucking up the efficiency and development of financial intermediation).

A major motivation for its introduction was to substitute for hard-to-collect taxes on short- and long-term capital gains on stock market transactions.

If that remains an important justification, I would suggest the following modifications: halve the rates of the STT (which will reduce the efficiency costs but retain the alleged informational benefits for tax authorities); double the present rate on short-term equity capital gains from 10 to 20 per cent (thus bringing it closer to rates on capital gains from other assets); and raise the rate on long-term equity capital gains from zero to 10 per cent (surely more equitable than a complete exemption, especially in a regime where dividends are also tax-free in recipients' hands).

These suggested changes would reduce efficiency losses, enhance equity (in the sense of fairness) and increase revenue. And the Left should find it easy to support these changes.

The strictures against taxing financial transactions also apply to the BCTT, introduced in 2005. The tax was justified as a measure to check evasion and black money generation. This is rather odd since the tax is likely to have the opposite effect of inducing black money operators to stay away from the banking system and conduct their operations purely in cash.

If revenue was the objective, then the BCTT has been an abject failure, having raised a derisory Rs 89 crore (Rs 890 million) in the first half of 2005-06. Such taxes also set very bad examples to state governments. Under these circumstances, the best solution would be to simply or withdraw this bad and ineffective tax.

The tax, which has been opposed the most is the FBT. The criticisms have been strong and largely justified. First, contrary to the finance ministry's claims, the FBT does tax legitimate business expenses such as sales promotion, telephones usage, and business travel.

Second, like all presumptive taxes, its burden on businesses is uneven and unfair.

Third, in practice, it is a complicated tax. Any tax which requires a 40-page explanatory circular (of the kind issued by the finance ministry in August 2005) cannot be simple!

The proliferation of special dispensations and rates for particular categories of expenses for specified industries (and there will be more of them if the tax stays) also adds to complexity and arbitrary incidence.

Fourth, the application of the tax imposes a lot more paperwork and administrative costs on businesses.

Fifth, such a complex tax is likely to spawn a large amount of discretionary abuse.

Finally, the revenue yield does not seem to be substantial: collections in the first half of 2005-06 were only Rs 822 crore (Rs 8.22 billion), according to the finance ministry's mid-year review (under the Fiscal Responsibility Act) issued last month. Indeed, as this newspaper has commented editorially (January 12), the FBT encourages companies to reduce the effective tax rate by paying more to employees in the form of perks.

The present finance minister used to portray the ideal of gently extracting revenue from taxpayers through the imagery of a bee sipping nectar from a flower.

By this analogy the FBT would seem to be a very large and fearsome bumblebee chewing remorselessly on shrinking violets!

Not surprisingly, various industry associations have proposed schemes for exemption from the FBT in return for paying a company tax higher by one or two per cent than the general rate of 30 per cent.

I recall Rahul Bajaj offering such a "trade" in a TV panel discussion on Budget day last February. Going forward, this seems to be an eminently sensible approach: abolish the FBT and raise the company tax rate by a per cent or two instead.

To sum up, confronted by three bad taxes, my recommended strategy for damage limitation is to: halve the rates of the STT and recoup the revenue by increasing the rates of the capital gains tax on securities transactions; abolish the BCTT; and withdraw the FBT while raising the corresponding revenue through a marginal increase in the company tax rate.

Do I expect these suggestions to be implemented? Well, as the bard said, hope springs eternal in the human breast…