TAX REFORMS IN INDIA

Context: This topic is important for GS Paper 3.

Introduction to Tax Reforms in India

• Taxation is not just a vehicle for raising state revenue. It can also be critically important for economic and political development.
• In recent times, India has introduced some far-reaching reforms to increase compliance (like Goods and Services Tax (GST), reduction in corporate tax rate and phasing out of exemptions, etc.) and to reduce tax evasion (like Place of Effective Management, Black Money Act, etc.).

India remains largely a tax non-compliant society- •

Only 6.08 cr individuals pay taxes (~4.9%) much below the desired level of 23%.

• In India, only 15.5% of net national income is reported.

• Overall, the Tax-to-GDP ratio (at 17.82% in FY 2017-18) still remains below that of emerging economies (~21%) and much below OECD average (~34%).

Reasons behind low Tax-to-GDP ratio in India-

• Low tax base:

Income Tax: The exemption threshold of income tax has been consistently raised, well-off people are subsidized at the cost of services.

Corporate Tax: Before the recently unveiled tax cuts, India was branded as a high-tax destination with a corporate tax rate over 30%.

• Tax Evasion: Tax evasion and corruption undermine the legitimacy of the State. It creates a belief among the citizens that public resources are being wasted, reducing the willingness to pay.

• Weak Tax Administration: This is considered a key barrier to effective and fair tax collection in the country. Due to lack of technical expertise and financial resources, as well as due to corruption.

• Structural Issues: Several structural factors have impinged upon India’s tax revenue performance such as:

A) Large share of agriculture (historically untaxed sector) & service sector (lightly taxed sector).

B) Low literacy rate and largely rural population.

C) Large informal economy partly due to onerous regulations on businesses, including labour regulations and high corruption.

D) Low financial development, due to which financial transactions are conducted in cash, making it difficult to track tax evasion.

Implications of low Tax-to-GDP ratio-

• Limited Fiscal Capacity: Low Tax-to-GDP ratio reduces the resources available to the government and puts a constraint on Government spending.

• Government Accountability: The state's role is to create the conditions for prosperity for all by providing essential services and protecting the less well-off via redistribution. In tax-compliant societies, Govt is more accountable to citizens. So, there is a better provision of essential services to people.

• Citizen Participation in Governance: Taxation is two-way relationship as part of the social contract. It is the responsibility of citizens to hold state accountable. If a citizen does not pay, he becomes a free rider (using the service without paying), and cannot complain if the state provides a poor quality service. If he exits (not using the service at all), he loses interest in holding the state accountable.

Direct Tax Reforms-

Background:

• Various committees, to consolidate the direct taxes, were constituted by the government like Raja Chelliah Committee (the early 1990s), Vijay Kelkar Committee (2002), and recently Easwar Panel.

• Recently, with the constitution of Arbind Modi Committee on Income Tax Reforms and Akhilesh Ranjan Panel on formulating a new Direct Tax Code (DTC), Government seems to be moving firmly in the direction of Direct Tax reform.

• Direct Taxes Code (DTC) aims to revise, consolidate and simplify the structure of direct tax laws (like Income Tax Act, 1961; Wealth Tax Act, 1957) in India into a single legislation.

Need for Direct Tax Code (DTC)-

The Income Tax Act 1961 should be redrafted to account for the structural changes in the Indian economy, new models of doing business (e.g. international businesses, digital businesses, etc.), and evolving methods of income calculation based on the objectives of economic policy.

• Rationalization and simplification of Income Tax Structure:

1. The rate structure – slabs of 10%, 20% & 30% in personal income tax - has broadly remained the same in the last 20 years. Further, there is a need for rationalization of exemptions and a rethink of incentives on savings (such as small savings schemes like PPF).
2. Over the past two decades, countless amendments, deletions & additions in the Income Tax Act, 1961 has made it incomprehensible to an average taxpayer.
3. The problem has been further compounded by judgments (often conflicting) on ambiguities rendered by the courts at different levels.

• Simplify corporate tax rate structure and phase out exemptions

1. The differential ineffective corporate tax rate across sectors is very high. E.g. in 2014-15, effective tax rates for cement manufacturers, consultancy service firms and banking service firms were 9 %, 16 % and 35 % respectively.
2. Moreover, the exemptions to corporate tax are not equitable vertically. E.g. in 2014-15, small companies having a profit of up to ?1 cr paid an average tax rate of 29.37% while companies having a profit of greater than ?500 cr paid an average tax rate of only 22.88%.
3. According to Ministry of Finance, in 2014-15, there were a total of 32 exemptions on corporate tax that had a projected impact on revenues of around ?1 lakh crore.

• Wide tax base will help deal with the problem of potential revenue loss due to lower tax rates and simplified tax structure.

• Reducing tax litigation: Tendency of tax officials to initiate an action without the necessary justification or assessment is reflected from low success rate of appeals (~30%).

1. Protracted tax litigation in India has not only put a burden on Indian judiciary but has also cost the government exchequer.
2. Reduction in tax terrorism is needed through clarity in taxation framework in the country and by reducing the discretionary powers of the tax department.
3. New Act needs to provide for alternate methods of dispute settlement such as negotiation, mediation etc.

• Provide level playing field between large businesses and start ups & young companies: A complicated tax structure in effect helps large business groups who can manipulate the system with the help of their in-house tax experts (tax avoidance strategies).

• Taxation based on Ease of Doing Business: Traditionally, for the sake of administrative convenience, the tax laws have segregated tax-payers only on the basis of ability to pay. It has seldom tried to differentiate between high-risk & low-risk income; legal & illegal income; recurring & non-recurring income etc. Considering such nuances in tax policy would make the structure more equitable. E.g. treating income from earned for Government securities (one of the most secure sources of investment) at par with high risk business income or share holder income is an anomaly that needs to be addressed.

• Ensure balance between direct and indirect taxes: Contribution of direct taxes has declined from 60% in 2010-11 to 52% in 2017-18. Increasing share of indirect taxes in revenue is alarming as indirect taxes are regressive which hurt poor people more.

• Clarity in cross border transactions: Till now, source rule of taxation for non-residents was linked to physical presence (permanent establishment) which has led to protracted litigation, base erosion and profit shifting.

• Better sync with global economy: Since India is much more integrated with the world globally in terms of business linkages and capital account convertibility, the differential treatment of foreign and domestic companies in the country should be gradually phased out.

• Need of Technology infusion in the tax administration to improve efficiency of tax collection as well as to aid the taxpayer.

Measures taken by the Government-

• Increasing Tax Compliance

1. CBDT launched ‘E- Sahyog’ portal to facilitate the online filing of the returns
2. Project Saksham was launched by CBIC to help in the implementation of Goods and Services Tax (GST) and in the extension of the Indian Customs Single Window Interface for Facilitating Trade (SWIFT).
3. Extending the scope of Tax Collected at Source (TCS): For e.g. 1% TCS is charged on luxury items (cars > 10 lakh/ cash payment > 2 lakh) collected by the seller.
4. Push towards digitalization and formalization will increase the expansion of the tax net.

• Anti-Tax Avoidance Measures

A) Advanced Pricing Agreements (APAs): APA is an agreement between a taxpayer and tax authority determining the transfer pricing methodology for pricing the taxpayer’s international transactions for future years.

B) GAAR (General Anti-Avoidance Rules), effective from April 1st, 2017, is a set of rules which helps the revenue authorities to decide:

1. whether a particular transaction has commercial substance or not
2. (ii) tax liability associated with a genuine transaction.

? It enables Government to tackle instances of tax avoidance due to practices like transfer pricing, round tripping (parking money in low tax jurisdictions and rerouting it as FDI or FII) etc. E.g. Vodafone Case

? GAAR provisions are applicable on firms who claim a tax benefits of over ? 3 crore.

C)Place of Effective Management (POEM) guidelines were introduced for the determination of residency of foreign company, applicable from FY 2017-18. If PoEM of a firm is in India, then its worldwide income would be taxed here.

? It intends to curb the formation of shell companies, which are located abroad but controlled from India, mainly for the purpose of avoiding taxes.

• Efforts to curb black money/tax evasion

1. India has signed up for a multi-lateral regime for sharing of financial information known as Automatic Exchange of Information (AEOI) with European Union and Switzerland.
2. India has also entered into information sharing agreement with USA under Foreign Account Tax Compliance Act (FATCA) of USA.
3. Recently, India made modifications in Double Taxation Avoidance Agreement (DTAA) with Mauritius & Cyprus so that all transactions attracting capital gains tax for investments made out of such tax havens will be taxed at full rate prevailing in India.
4. Operation Clean Money and Project Insight was launched to use data analytics to improve tax compliance and effectively utilize information in tax administration.

• Corporate Rate Cut: To boost industrial activity and increase compliance, tax rate for all corporates is reduced from 30% earlier to 22%. Effective tax rate for all domestic companies would now be 25.17% – nearly 10% less than the existing 34.94%, providing they don’t avail any exemptions. New manufacturing companies will have to pay an even lower corporate tax rate of 15%.

• Administrative Reforms: Based on the recommendations of Tax Administration Reforms Commission under Parthasarthi Shome, a Tax Policy Research Unit headed by Revenue Secretary has been created for better research capability on fiscal topics and a Tax Policy Council chaired by Union Finance Minister to help the government make better policy decision on tax policies. The panel also recommended integration of CBDT & CBIC for holistic tax compliance regime.

Suggested Reforms

• Tax treatment of cross border transactions: Arbind Modi Panel on Income Tax Reforms recommended that an income shall be deemed to be derived from a source in India, if the payment has been made from India, for any goods/services consumed or towards interest, dividend, bonus, or any other return on capital.

• Reintroduction of wealth tax: Moderate rates of personal income tax are not sufficiently progressive to contain growing inequality. Thus, wealth tax can be reintroduced.

1. However, in order to keep the compliance cost low and prevent protracted litigation as experienced under the Wealth Tax Act, 1957, the valuation of the assets should be done transparently.
2. Threshold limit should be such (for e.g. ?10 cr) to keep the middle class out of the purview of this tax.
3. It will help fill the void created by the inadequacy of property tax at the local level.

• E-assessment: New Income Tax Act should provide a complete legal framework for the introduction of e-assessment based which will be paperless and faceless. It will enhance efficiency, effectiveness and accountability and eliminate all opportunities for rent seeking behaviour.

1. In faceless assessment, tax-payer doesn’t have to appear before the assessing officer neither will he know who is assessing his/her return. Information will be sought from the assessee via email and there will be no physical movement of the document.
2. Budget 2019-20 has initiated ‘faceless assessment’ on the pilot basis.

• Dispute resolution mechanism: A Directorate for Public Rulings has been created mandated to issue preassessment clarifications to prevent litigation and provide certainty. Similarly, in-house dispute resolution panel must be empowered to settle disputed issues.

Editorial: The Recovery Toolkit

The economic recovery remains fragile; rebooting tax policy may help

• The latest string of official numbers, including almost-record GST collections, healthy direct tax inflows, strong manufacturing and exports, provide some confidence that the economy has lurched back from the danger zone for the second time in less than a year owing to the COVID-19 pandemic.
• But the healing is still too uneven. GST revenues in October, for transactions done in September, crossed ?1.3-lakh crore. The Finance Ministry believes this kitty would have been higher if sales of cars and products dependent on chips were not afflicted by shortages.
• If September’s activity reflects pre-festive stocking, the actual festive spending (October-November) may keep GST numbers propped up, but it would be critical to wait for the post-celebration trajectory.
• October has offered mixed signals so far — manufacturing has seen a surge in output and new orders, domestic and global, but continues to shed jobs, as per the IHS Markit Purchasing Managers’ Index.
• Moreover, manufacturing rivals Vietnam and Indonesia have seen a sharper rise. Diesel consumption, a better indicator of commercial throughput, has been lower than October 2020, while credit growth, rail passenger revenues and traffic congestion have been insipid.
• India’s exports have held strong, but the import bill is rising too as coal, fuel and edible oil prices shoot up.
• A hovering fertilizer crisis could yet dampen rabi crop and hit farm sector growth. While that could trip rural demand, rising oil prices pose a persistent threat to growth.
• Growth engines will remain throttled rather than go full throttle towards the Centre’s five trillion-dollar goal for the economy, unless consumption and investment bounce back.
• With token tax cuts on petrol and diesel, the Government is clearly changing tack from narratives about the high fuel taxes funding free vaccines and welfare schemes that can only hold legs for some distance.
• Whether this is prompted by recent electoral setbacks or in anticipation of the bigger State polls ahead, it may need to follow up with more tax cuts as global prices are expected to firm up further.
• The urban poor have been hit the hardest by the high inflation prevailing since the pandemic’s onset in 2020. They, along with the much-celebrated Indian middle class, have the highest propensity for upward spending on consumer durables, homes, two-wheelers, and so on.

Way Forward

Well-planned and structured taxation as per economic needs would make people self-reliant just as the nation aspires to be, and that would trigger a virtuous cycle for the economy.