With two important documents, namely, the Kelkar committee report on direct taxes and the mid-year review of the economy, being brought before the general public, there is enough material available to analyse the recommendations of the Kelkar committee on tax policy against the current economic situation.
The increase in the fiscal deficit continues to be a cause for concern.
The fiscal deficit, as a proportion of gross domestic product, has jumped from 4.1 per cent in 1946-47 to 5.9 per cent in 2001-02.
The mid-year review suggests that there is a need for purposeful movement towards fiscal consolidation with a fiscal order that is of global standards.
A review of tax policy generally includes a review of the tax-to-GDP ratio.
The tax-to-GDP ratio of India -- around nine per cent as against 12 per cent in Pakistan, 20 per cent in the United States, and around 34 per cent in the United Kingdom -- is comparatively low and it has declined over the past 20 years.
However, it is important to analyse the ratio of income tax revenue to GDP, which is around 3 per cent in India and Pakistan as against 14 per cent in the United Kingdom and 12 per cent in the US. This ratio has increased in India from 2 per cent in 1984 to 3 per cent in 1997.
The government also needs to examine the contribution of individual and corporate tax revenue to total tax revenue. While this contribution is more than 70 per cent in the UK and the US, it is around 20 per cent in Pakistan and 50 per cent in India.
Thus, while the tax-to-GDP ratio in India is declining, the income tax-to-GDP ratio is increasing. If, in spite of the decrease in the tax-to-GDP ratio, the ratio of income tax to GDP is increasing, it certainly suggests that the share of indirect taxes in total tax revenue is decreasing subsequently.
However, the share of individual income tax revenues to total income tax revenue is lower as compared to the developed countries.
The personal income tax rate structure is most crucial if the government wants to generate the desired tax revenue in an equitable manner. It covers three things -- the exemption limit, tax rates and the level of income at which these rates are applicable.
The Kelkar committee has recommended that the exemption limit be raised from Rs 50,000 to Rs 1,00,000. If we look at it from the point of view of subsistence-level requirements, then it is justifiable that at least Rs 1,00,000 a year should be tax-free so that an individual fulfils his minimum requirements.
However, considering that currently only around three per cent of the population are taxpayers in India, as against 46 per cent in the US, 48 per cent in the UK and around 53 per cent in Australia, the ratio of individual taxpayers in India to total population, which is quite low, will drop further with the proposed increase in the exemption limit to Rs 1,00,000.
The present exemption limit of Rs 50,000 is already more than the per capita GDP. If the exemption limit is raised to Rs 1,00,000, the gap between per capita GDP and exemption limit will increase.
In the UK, US, Australia and even in Malaysia, the basic exemption limit is much lower than per capita GDP.
In its report, the Kelkar committee mentioned that the tax rates affect economic behaviour and the compliance behaviour of taxpayers.
It endorsed the principles suggested by the report of the advisory group on tax policy and tax administration for the Tenth Plan, that the number of tax slabs should be few and that the maximum marginal rate of tax should be moderate so that distortions in the economic behaviour of taxpayers and incentives to evade payment are minimised.
Accordingly, the committee has recommended reducing the number of slabs from three to two.
The maximum tax rate remains unchanged at 30 per cent. However, the level of income at which the maximum rate of 30 per cent will be applicable has been increased from Rs 1,50,000 to Rs 4,00,000. This increase in income level was overdue.
For many years, though maximum tax rates remained stagnant at 30 per cent, these were, however, payable not only by high-income group earners but also by the medium-income group earners.
So raising the income level from Rs 1,50,000 to Rs 4,00,000 is justified as far as the lower and middle income group earners are not required to pay the maximum marginal tax rate of 30 per cent.
While designing the tax rate structure, it is desirable to consider the practice prevalent internationally. Consider the minimum and maximum tax rates applicable in some countries along with the number of slabs.
As far as the personal income tax rate structure goes, these countries follow a progressive tax rate schedule. The number of slabs in general is four or more.
Although the maximum marginal tax rate varies from 28 per cent in Malaysia to 47 per cent in Australia, the level of income at which the maximum tax rate is applicable in India is much lower than the level of income at which such rates apply in other countries.
There are variations in the minimum tax rates as well, ranging from 1 per cent in Malaysia to 17 per cent in Australia. It appears that most countries have followed the 'ability to pay' principle.
The Kelkar committee recommendation to raise the exemption limit from Rs 50,000 to Rs 1,00,000 and to reduce the number of slabs from three to just two does not fulfil either the ability to pay principle or the revenue consideration.
Raising the limit to Rs 1,00,000 (that is, double the existing limit) to all taxpayers will have a serious impact on revenue collections.
To have an equitable tax system without any adverse impact on revenue, we could adopt the US system of allowing personal exemption that is phased out instead of a tax-free threshold.
The amount of personal exemption could be kept at Rs 1,00,000 subject to phasing out.
The phasing out could start at the total income of Rs 2,50,000 at 20 per cent of excess total income over Rs 2,50,000. As a result, the amount of personal income at different levels will be as follows.
Thus, those with a total income of Rs 7,50,000 and above will not be provided any exemption. The tax rate structure should be made more progressive so that individuals bear tax on the basis of their capacity to pay.
The tax burden on the basis of this tax rate structure will be lower for low income group individuals and the burden will increase gradually as income increases.
The maximum rate of 30 per cent will be payable only on income exceeding Rs 6,00,000.
Thus, the Kelkar committee's recommendation to reduce the number of slabs from three to two does not seem logical.
Instead of making the tax rate structure inequitable and inconsistent with the trend in other countries, the government should ensure better taxpayer compliance and create confidence among taxpayers that it will utilise the money for the welfare of the general public.
Are Kelkar's proposals good for the mutual funds industry?
The Kelkar committee has made the following recommendations for taxing of mutual funds.
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The income of the mutual fund derived from short-term capital gains and interest should be taxed at a flat rate in the hands of the mutual fund.
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Since most investors in units are generally smaller taxpayers, we recommend that the rate of tax should be the minimum marginal rate of personal income tax i.e. 20 per cent.
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With a view to overcoming double taxation, the dividends received by unit holders should be fully exempted since the distributable surplus would have suffered the full burden of the tax.
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The short-term capital gain arising to the investor from the sale of units of investment funds should be taxed at his level at the personal marginal rate of tax.
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The long-term capital gain arising to the investor from sale of units of mutual funds should be exempt from income tax.
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The tax treatment of mutual funds and their investors should also be extended to venture capital funds, private equity funds and hedge funds. However, the tax rate for these funds should be 30 per cent since their investors are likely to be those in the highest tax slab.
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All funds must necessarily obtain the PAN of the investor and the database about every payment made by the fund manager back to the investor, tagged with PAN, should be furnished to the tax authorities as a information return.
The net impact of Kelkar's proposals will be beneficial to investors in the higher tax bracket, since short-term capital gains will be taxed only at 20 per cent. Currently, capital gains are taxed at the personal income tax rate.
A 20 per cent short term capital gains tax in the hands of mutual funds will impact portfolio turnovers to some extent since fund managers will have to factor in the additional burden of tax while making buy and sell decisions.
However, industry experts feel that Kelkar's recommendation to tax short-term gains in the hands of the mutual fund involves too many complications and may be far too difficult to implement.
Additional inputs: Business Standard Smart Investor Team
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