Monday, May 20, 2024

An ideal trinity of tax, growth and equality is possible

India’s direct tax-to-GDP ratio is low, a fact acknowledged by everyone, including the government. This was a main theme of the Economic Survey of 2017. A higher ratio requires higher tax collections, which in turn needs higher GDP growth. The latter requires investor-friendly tax rates, both on individuals and corporations. But low direct tax rates can also lead to higher income inequality. High inequality in turn prevents widening of both the base and scope for increasing the tax burden on a large part of the population. Resorting to a higher share of indirect taxes such as GST makes everything more regressive, and hurts the poor more. Thus, we need direct tax reform that is progressive. We need sustained high growth powered by investors. And also lower income inequality.

Is this an impossible trinity? Does wooing investors necessarily mean keeping direct taxes low? Does high growth necessarily lead to higher inequality, a la Thomas Piketty? Not necessarily. We can find a middle path if we can tiptoe our way to genuine direct tax reform, while keeping incentives for private investment intact (and robust). A small step towards tax reform was slipped in as a last- minute amendment in the Union budget. It takes away a tax exemption enjoyed by bond investors, which is denied to bank depositors. It means that now income earned via interest on a bank fixed deposit is treated at par with capital gains made through a debt mutual fund, and is taxed as normal income. This is an important step towards treating all income uniformly, whether earned as salary, interest, dividend or capital gains. All income should be taxed in the hands of the receiver irrespective of its source. This is the essence of direct tax reform, which has been pending for far too long.

This basic principle has been distorted in several ways. Income earned as a return on assets depends on the type of asset (stock, bond, real estate, gold, etc), as well as the holding period (short or long term). In the case of a long holding period, an additional wrinkle is the benefit of inflation-indexation. Not only does this make filing taxes very complex (you have to keep track of the exact date when an asset was purchased to compute this benefit), but it also opens up myriad ways of arbitrage. It also keeps tax inspectors busy, as they probe whether a tax shelter being used is legitimate or not. Income earned as stock dividends was tax-free for over two decades, starting with that “dream budget” of 1997. Thankfully, we ended that nightmare three years ago. Dividends are now taxed as normal income. The earlier tax-free treatment of dividend income in the recipient’s pocket was offset by a dividend distribution tax on the company, which had caused its own distortions, since it treated all earners in the same tax slab, which meant that higher tax-bracket earners got an extra benefit.

The Indian mutual fund industry’s assets are nearly 40 trillion, more than one-fourth of bank deposits. Even though the first mutual fund was launched 60 years ago, this industry was considered nascent till recently. That is why it had to be given special tax concessions, to nudge savers away from banks. But now this industry is mature enough and does not need any extra and unfair props. As the financial sector deepens, and various financial markets undergo integration, it becomes easier to move towards the holy grail of treating all income uniformly. While long-term gains on bond funds have come under this new treatment, gains on zero-coupon debenture funds are still not included. Will they be next? What about uniform treatment for all asset classes?

A Bloomberg report this week hinted that the government was going for a comprehensive overhaul of the capital gains tax regime to make it more fair, asset neutral, and hence inequality-reducing. This was denied by the finance ministry, which was probably anxious not to spook investors further. The ministry being this shy points to how difficult it is to navigate the trinity of tax reform, higher growth and lower income inequality.

Unlike consumption spending, which can be relatively inelastic to price increases, investment spending is more jittery. Markets can have knee-jerk reactions. In the past, as India toyed with tweaking the securities transaction tax, there were near-violent reactions, and ministers had to calm nerves as well as retract. Let’s not even go near the reforms required to inject more transparency in the participatory-notes system, which is currently opaque and can potentially enable tax evasion. But it does invite foreign investors.

The point is that higher and sustained economic growth needs large doses of private capital to flow in year after year. Capital is much more globally mobile, and gets turned off at the slightest sign of any adverse tax move, or more regulation and disclosure. Cases like the ill-fought tax disputes with Cairn and Vodafone have left a bad taste.

Yet, India needs to move towards increasing the share of direct taxes and decrease that of indirect taxes. The blueprint for tax reform was laid out 20 years ago by a task force headed by Vijay Kelkar. Most of those ideas remain completely valid and relevant.

A simpler code, lower taxes and minimal exemptions are the basic principles of reform. Moreover, advances in technology and better taxpayer data, as well as data triangulation, make tax reform easier and evasion harder. The trinity can indeed be achieved.

Ajit Ranade is a Pune-based economist

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