KELKAR REPORTS ON TAXATION

Soon after he became finance minister, Jaswant Singh commissioned two reports on taxation from Vijay Kelkar. They were good reports which gave me much material for reflection. I wrote a five-part series on them in Business Standard in November and December 2002.

RETHINKING THE TAX REGIME

I    Personal taxes

The new Finance Minister appointed two task forces under the chairmanship of his new adviser, Vijay Kelkar, on direct and indirect taxes respectively in the first week of September. The first was to report in 55 days, the second in 45. The time frame defined what was possible. The task forces could re-evaluate and repackage what other similar enquiries had done before; they could not start de novo. Being internal committees with secretaries from revenue departments, they could propose anything the revenue collectors disapproved of. Thus they could only be expected to produce rather tame, conventional reports. It is to Kelkar’s credit that despite all those constraints he has raised a hornet’s nest.

The Consultation Paper on direct taxes has attracted the most comment – chiefly on personal tax proposals. Typically, a chartered accountant works out how much taxpayers would pay under the present and the proposed rates, and incites those who would pay more. To the extent that the task force has tried to balance tax gains and losses, someone’s loss must be someone else’s gain – perhaps even his own. But the CAs would not be interested in anyone’s gains; only losses are news. If we are considering national interest, however, it is necessary to go beyond this elementary arithmetic and apply a bit of economics.

On personal taxes, TFDT proposes raising the exemption limit from Rs 50,000 to Rs 100,000. This limit has not been raised for seven years if I remember right, and it is time to raise it anyway. CBDT always resists a rise because inflation lowers the limit progressively in real terms and brings an increasing number of taxpayers into its net. Few finance ministers have the guts to take on the revenue departments, so the purpose of every rise is defeated as time goes. The rational procedure would be to fix the limit in real terms and raise it together with inflation every year.

More important, TFDT proposes to replace the present three personal rates by two. Incomes between Rs 100,000 and Rs 400,000 would be taxed at 20 per cent and incomes over Rs 400,000 at 30 per cent. This is how the British income tax, the first in the world, was designed: leave a certain subsistence income untaxed, and then apply a relatively heavy “basic” rate like 30 per cent to a wide band of income. The opposite design, consisting of a lot of progressive tax brackets, became popular in and after World War II. The idea was to take away all income beyond the subsistence level defined for each income class – a semi-socialist idea that rested on the superiority of public over private uses of income. That idea is now dead. Besides, high marginal rates lead to evasion and to pressure for exemptions and rebates.

On the other hand, if there is a broad middle band, the income elasticity of tax is lower, but people notice income tax less. The same 20 per cent gets taken away as income rises, and once people get used to the rate, they stop minding it. Two questions arise here: what should the basic rate be? And how wide should the middle band be? On the first, it can be argued that it should be low – 5 or 10 per cent – so that people would mind becoming taxpayers less. But if it is low, it will not raise much revenue; that is why the British keep it high. On balance, I prefer Kelkar’s 20 per cent, but would impose it at a higher level – more like Rs 150,000 or Rs 200,000; after all, even manual workers typically earn more than Rs 10,000 a month these days. And I would have a wage tax of 1 or 2 per cent, which I would use to give free life and accident insurance and very limited unemployment benefit; workers would be able to increase their cover by voluntarily contributing more. I would abolish the second pension and merge the payments for it with this minimum tax. I am in favour of the top rate of 30 per cent. Internationally, top rates are ending up between 30 and 45 per cent, and the trend is downwards; since we got to 30 per cent, we might as well as stay there – without the surcharge.

The case for abolition of exemptions is unrelated to the case for reducing rates, though they get connected in official minds that want to balance tax gain and loss. Exemptions are not wrong in themselves, except that they increase complexity, distortions and incentives to cheat. But all the exemptions whose abolition TFDT recommends are unjustified, and should be abolished. The concessions to specified financial investments are expensive to revenue, raise returns on them to absurd heights, and lack all rationale in today’s economic conditions

The tax on dividends was abolished by Chidambaram; then, Sinha, in an final bout of folly, brought it back this year. Now TFDT proposes its reabolition. This is obviously correct; dividends are taxed twice, in the hands of companies and of receivers, and one of the two taxes must be removed. Otherwise, companies will prefer to borrow on interest, since they can charge interest off against profits, whereas they cannot dividends. But TDFT wants to confine the exemption to dividends from Indian companies. Poor drafting: it means companies registered in India. And it is wrong on that: foreign companies pay taxes in their own countries, and taxing dividends they pay in India will only invite claims based on double taxation agreements –  typical CBDT grasping attitude, and all wrong.

I am not, however, sure about TFDT’s proposal to abolish capital gains tax. It says the distinction between carried forward depreciation and other business losses should be abolished. Just as depreciation is just another loss, capital gains are just another income. Exempting them would distort incentives: companies would be tempted to retain profits rather than distribute them, and accumulator funds would convert dividends into capital gains. Exemption would also reduce the mobility of savings across investments. But capital gains are lumpy: they may accrue over years and be realized at one point of time. If they are taxed at that point, they may bear a higher tax than if they had been spread out over the years. One way of dealing with the problem would be to spread them out and recalculate the tax due for those years. That is too complicated. The other is to charge them at a lower rate. I think taxing them at TDFT’s lower rate of 20 per cent would be a good compromise.

II    Depreciation is not evasion

People’s income represents the accretion to their purchasing power – and hence their power to enjoy themselves – in the year. It seems fair that those who can enjoy themselves more should sacrifice more to keep the government running; that is the case for progression. But people may earn money which they cannot use to enjoy themselves – for instance, they may have to buy materials, or employ people, or go and see their clients. The expenses incurred to earn the income should obviously be deducted before the income is taxed. Hence in the case of producers or value adders, taxable income is the difference between revenue and essential expenses, or profit.

Should that profit be taxed in the hands of businesses or in those of their owners? Ideally in the latter’s hands. But if it is not distributed to them, they will have to pay tax on income they did not receive, and may run short of cash. Hence it has to be taxed in the hands of businesses.

If expenses are not taxed, a business will have an incentive to maximize expenses, and its owners to pass off expenses on things that they enjoy as expenses of the business. So once a tax on businesses is introduced that is separate from the tax on individuals, revenue authorities have to keep making judgments on (a) whether an entity is a person or a business, and (b) if it is a business, whether it is trying to pass off a personal expense as a business expense.

It was (a) that exercised my colleague TCA Srinivasa Raghavan no end some weeks ago: he felt that people like him were passing themselves off as businesses, and that the revenue authorities were allowing them expenses on the basis of a standard ratio that was too high – and thereby giving all persons an incentive to pass themselves off as businesses. I think the answer to this is that even persons that are not businesses should be allowed to charge expenses that are essential to earning their livelihood. The number of individual taxpayers is so high that checking their expenses would require the employment of a huge tax collector force. Hence it is necessary to adopt a rule of thumb. This is the rationale of the standard deduction for employed people, which the Kelkar Task Force on Direct Taxes (TFDT) has erroneously recommended the abolition of. But the standard deduction should not be a constant amount; it should be proportional to income. That the CBDT should allow a similar, informal standard expense ratio for small businesses seems to me to be a just approximation.

The other problem, that expenses should be passed on to businesses, is bound to arise if the tax rate on the beneficiary is higher than on the business. If the personal tax rate exceeds the business tax rate, the owner of a business will save tax by passing off his own expenses as the businesses. This is why the business tax rate should be the same as the peak personal tax rate – as the TFDT has recommended.

But equalizing the two tax rates will still not remove the incentive for a business to spend as much as possible and not make any taxable profits at all. Tax authorities have to monitor and police such tendencies. It is actually done by means of extremely detailed rules about allowable expenses, and is mired by intricate lawsuits and court decisions. The income tax officer also exercises considerable discretion. This is why jobs on the corporation tax side are prized by income tax officers.

It is this jungle of rules, judgments and discretion that the TFDT should have looked at. It had neither the time nor the expertise to do so. So it has followed Kelkar’s megaprinciple and looked for exemptions to abolish; for the rest it has advanced certain proposals pressed upon it by the tax authorities. It says that “the erosion in the tax base is evidenced by the divergence between the statutory corporate tax rate and the effective tax rate….the effective tax rate of a sample of 2585 companies in 2000-01 was 21.9 per cent as against the statutory rate of 39.55 per cent. This is in spite of the provisions of Minimum Alternate Tax (MAT) which is, in itself, a sore point with trade and industry.”

Being an official report, it never cites sources; but the presence of Ajay Shah in the ministry makes it pretty certain that the figures came from the CMIE database. But then Ajay Shah should in fairness have told the TFDT precisely how the difference between 21.9 and 39.55 per cent arose. It arises almost entirely because of the fact that expenditure on fixed assets – buildings, plant, machinery etc – is lumpy and the accounting practice is to charge that expenditure, not against the profits in the year in which it was incurred, but in a series of years on a declining balance or a straight-line basis. Tax authorities accept this practice. But the speed at which the assets are depreciated affects the time pattern of the revenue: the faster they are depreciated, the more unstable the revenue. So the tax authorities lay down very, very slow allowable rates of depreciation. But even with these allowable rates, in years of low capital expenditure, such as recent years have been, the actual tax rate will be lower than the maximum. This is the cause of the difference between 12.9 and 39.55 per cent, not some jiggerypokery by companies.

But for a business, depreciation is just a form of reserve, or accumulated profit; if it is making big profits it may want to write off its fixed assets faster. It can thereby retain more profits, reinvest them, build up its assets faster, and get an edge against competition. This is a perfectly legitimate practice. Professional audit regulators lay down good practice in this regard; companies may follow it, or be more conservative.

The TFDT wants to ban such discretion: it wants to impose the depreciation rates laid down in the Companies Act, and wants to put a ban on companies charging any other rate. This is completely wrong-headed; a company must have the right to dispose of its gross profits in any way it likes. If that confuses the tax authorities, it is only because of their laziness or incompetence. In these days of computers, it is most easy to convert the basis on which accounts are maintained; all that the tax authorities are entitled to do is to insist that companies keep two sets of accounts, their own and one for the tax authorities, and explain the difference between the two.

The State of the Economy 

III     Taxation as an instrument of policy

Last week I pointed out the error in the thinking of the Kelkar Task Force on Direct Taxes (TFDT) on depreciation. Briefly, governments cannot resist taxing business profits because they yield so much revenue with so little effort. As soon as they do so, they have to allow firms to write off business expenses. The firms will have an incentive to pass off personal as business expenses, and the tax authorities will prevent and police such a tendency; that leads to a plethora of laws, regulations and administrative and judicial decisions. Amongst them are rules about how quickly various assets may be depreciated. There the TFDT proposes that (a) the depreciation rules should be those laid down by the Department of Company Affairs, and that (b) companies must be forced to use these rates and no other. This proposal is wrong for two reasons: first, because it throws away the finance ministry’s freedom to vary allowable depreciation in order to encourage or discourage investment, and second, because it puts an unnecessary and unwarranted restriction on a firm’s freedom to choose depreciation rates for its own accounting.

I discussed this issue with three economists in the inner circle. One agreed with me. Another justified the proposal on grounds of stablility and predictability. The third considered the income tax department to be so corrupt and oppressive that the less discretion it had the better.

The argument on stability is important and has a general application. During World War II, governments regarded spending on the war a necessity for national survival; to finance it they raised income tax rates to confiscatory levels. After the War, governments found new reasons to retain the high tax rates. Some found new uses for the revenue, especially health and unemployment insurance and pensions. Others including India went socialist and made a virtue of soaking the rich. These confiscatory income tax regimes invariably led to evasion; to discourage it, governments gave concessions to approved uses of income, especially approved forms of savings and investment. These concessions were hedged around with restrictions, and the two together created complexity. These complex incentives were then made to reward the faithful and punish the infidels: conservatives increased concessions, radicals reduced them. Thus taxation became a political football. Finance ministers tinkered every year with the tax structure, and taxpayers anxiously awaited the budget.

Many countries have seen the folly of outrageously progressive tax rates. Such rates reduced revenue; and in poorly governed countries like India they did not even promote equity. As countries abandoned them, they also moved towards a simpler tax structure: a mildly progressive income tax, a proportional business profits tax at a rate comparable to the peak personal tax rate, and a tax on value added. In those countries that have gone over to this system, tax rates seldom change. In the European Union and its eastern dependencies this is due to an informal pact against tax competition. But stable taxes have also removed a major source of uncertainty for businesses, and made tax planning possible.

Thus a stable tax structure is desirable. India is moving willy nilly towards it. TFDT talks of two income tax brackets. Yashwant Sinha moved toward a three-tier excise rates – although, as Sukumar Mukhopadhyay has pointed out, he surreptitiously increased the actual number of excise rates. If the states move to a VAT next April, they to will have only two or three VAT rates. The Task Force on Indirect Taxes (TFIT) talks of two rates of customs duty. Thus absentmindedly India is simplifying the tax structure. But that will not benefit business because we are not simplifying tax administration. Every tax requires its own administration; each of them preys upon tax payers. Hence there is a point in reducing the number of taxes; and the minimum number of taxes is three – taxes on income, on assets, and on production. Thus we should move towards a structure in which there are no taxes other than a single income tax, a single tax on land, and a single tax on value addition = however many governments we may have. All governments should be allowed to levy any or all of the three taxes; but they should not be allowed to collect tax the taxes. The taxes should be collected by dedicated tax authorities, and the proceeds distributed amongst the levying governments. Kelkar has proved, in the two reports and the ensuing speeches he has given, that he is an evangelist, bent on his ideals regardless of tax accountants baying at his heels. If he wants to evangelize, he should choose a greater god – the god of a single, simple tax administration for the country.

Let me now come to the second argument – that a simpler tax system, with fewer concessions, is more conducive to honesty in the tax administration.  I myself subscribed to this theory when I joined the government. I found that the excise and customs department had issued hundreds of “notifications” – so many that it did not itself know how many it had issued. Each notification gave a concession to someone or restricted someone’s concessions. Each could be used by the beneficiary to make money, and some of that money could be passed back to the revenue officials. So I thought that removing notifications was a sure way of reducing corruption. Of course, the revenue departments were against this kind of simplification, and always came back with the argument that such and such a company would close without the exemption or, informally, that such and such a politician was behind it. So I suggested that the number of exemptions should be counted, and the revenue departments should be asked to remove any 20 per cent of them in the first year, another 20 per cent the following year, etc so that the entire rigmarole would disappear in five years. But before the exemptions even began to roll back, I was rolled out.

I still think that simplification and removal of privileges would reduce the scope for corruption. But it would not reduce corruption. As I said at the outset, taxes on business do require policing; and any policeman can be corrupt. Income tax officials can raid people without reason or withhold refund orders; customs officers can misclassify goods and extract a bribe for putting their own mistake right. Corruption cannot be eliminated by changing laws and rules alone, or by giving taxmen computers; you have to change tax officials and their mores.

IV    Unjust enrichment of the taxman

In 1984, a firm went to court because an excise officer had overcharged excise and refused to refund it. The government put forward the defence that the manufacturer would have passed on the overcharge to its buyers, who would be impossible to trace and reimburse, so it would be unjust to compensate the firm. This principle of unjust enrichment was embodied in an amendment to the Central Excise Act which would transfer the money to a government-controlled Consumer Welfare Fund. Manmohan Singh piloted it through Parliament soon after he came to power.

This amendment was challenged, and the Supreme Court gave a judgment in 1996. The majority approved the amendment to the Central Excise Act. Justice S C Sen dissented on constitutional grounds: “Article 265 forbids the State from making an unlawful levy or collecting taxes unlawfully. The bar is absolute. It protects the citizens from any unlawful exaction of tax. So long as Article 265 is there, the State cannot be permitted to levy any tax without authority of law and if any tax has been collected unlawfully that must be restored to the person from whom it was collected.”

Now suppose an excise officer goes to a manufacturer and says, “I am going to overcharge you by Rs 10 million. You can go to court and you will win. But you will not get the money back; it will go to the Consumer Welfare Fund. You might be better off if, instead, you gave me Rs 5 million.” That would be unjust enrichment of the taxman, made possible by the amendment. On this, the report of the Kelkar’s Task Force on Indirect Taxes (TFIT) proposes that tax overcharged should be refunded if it was charged on goods manufactured and consumed by the same firm. But this is pusillanimous. The Supreme Court judgments hold the amendment to be legal, but they nowhere make it mandatory. The government could take the view Justice Sen took, and reverse the amendment. I hope it will be done in the next budget.

The TFIT cites huge figures of duty lost on exports. The excise department is very fond of these figures, and presses them on all gullible suckers. The point is that the buyers of our exports are not Indian citizens; they are not obliged to pay taxes to our Excise and Customs. If our taxmen insist on taxing them, they will just go and buy the same goods from another country. That is why every country – at least, every country with revenue officials that can think – exempts exports of domestic taxes. The taxes that exports do not pay are not taxes forgone; they are just stupidity avoided.

Then there is this hoary canard of cascading – the idea that manufactures must bear higher import duty than inputs. As the Virmani report showed, it is impossible to make any neat distinction between inputs and outputs, and the impact of cascaded duties must remain haphazard. More important, the lower the value added in manufacturer, the greater the protection given by a differential duty. For instance, the TFIT has proposed an import duty of 5 per cent on crude oil and 10 per cent on products. The normal refining margin is 10 per cent. The cost of crude is 90 per cent of the value of products, on which 90 per cent the refinery would pay 4.5 per cent. With a 10 per cent product duty, it can sell the products at 110 (provided all refiners collude to raise the price to import-equivalent). So the cascading duty raises the refining margin from 10 to 15.5; a 5 per cent differential gives the refiner 55 per cent protection. That is why if there must be a duty, it were best a flat duty on all inputs and products.

The TFIT discusses customs and excise duty separately; but in fact, imports are made to bear both. First the landed price is calculated including import duty, and then excise is calculated on it. Thus an imported good bearing an import duty of 35 per cent and an excise duty of 16 per cent actually pays 56.6 per cent. The principle of charging both duties is itself suspect. An import duty is also a duty; there is no reason why a product that has borne it must in addition bear excise duty. A time may come when import duties fall below the excise duty; in which case the correct duty to charge should be the higher of the two. If the government wants to be greedy, it can add up the two duties: a customs duty of 35 per cent and an excise duty of 16 per cent can become a total duty of 51 per cent. But there is no justification for multiplying the two.

Following the Kelkar mega-principle, the TFIT looks for exemptions to abolish in respect of indirect taxes as well. But the biggest exemption, which cannot be abolished unless all import duties are scrapped, is to imports for the manufacture of exports. The customs department has encouraged the separation of the exporters from domestic manufacturers, through EOUs, EPZs etc. The TFIT has bought this view and suggested that domestic sales allowed to firms in these zones should be brought down from 50 to 10 per cent in two years. But segregation of exports in separate firms is undesirable; a firm should be able to access both the domestic and the export markets without hassles.

Here the TFIT rules out all devices other than duty exemption (through advance licences, presumably) and duty drawback. This is a typical revenue view. Duty drawback is in fact subject to enormous delays and horrendous corruption; this is the one device that should be scrapped. In general, we should look for an exemption that is conditional on exports, so that there is no need to check that promises to export are kept, one that is not transaction-specific and does not generate enormous red tape. The one device that meets these conditions is the Pass Book; no wonder the Customs hate it. But that is the best device, and I am glad Arun Shourie, the Commerce Minister-by-default, has assured the exporters of its continuation. The way to simplify the Pass Book and reduce hassles is to have only one import duty on all inputs; then the duty credit would depend solely on the import content, which the DGFT routinely certifies. And the way to make it redundant is to abolish all import duties. That will remove the handicap to exporters, as well as the temptation to cheat the duty exemptions pose before exporters. That is the best solution; Kelkar should embrace it.

V    What is worth doing?

The task forces under Vijay Kelkar’s chairmanship will submit final reports by the end of the year. A bare six weeks will be left for their proposals to be embodied into the budget or shelved. The reactions to the reports, from the ministry, the press and the lobbies, ensure that substantial parts of them will not be implemented – not, at any rate, in this budget. What, then, are the things worth doing in this budget? My list, though not entirely from the reports, at least has the merit of being brief and doable.

The most important thing to do is repeal of the Unjust Enrichment Act. As I have argued, this is just an act for the enrichment of corrupt excise officers; it serves neither justice nor administrative efficiency. The economic grounds for its repeal, namely that it creates an incentive for corruption, are the most important, and should be used above all else to justify the repeal. But insofar as legal grounds are required, they are available in the Justice Sen’s minority view in the 2001 Supreme Court judgment: that Section 65 of the Constitution forbids expropriation of a citizen without sanction of Parliament. The majority view gives the contrary argument: that excise duty is a tax on the final buyer and not on the producer who pays it, and that the latter will have passed on to the former any unfair or illegal charge made on the producer. This presumption of the learned judges is incorrect: the producer pays the excise, and as elementary economics teaches, its incidence – that is, its division between the producer and his customer – depends on the elasticity of demand for the product. In this country where a very large proportion of the producers is exempt from excise on account of their size, there is no economic presumption that every Rupee of excise paid by the producer is passed on.

The next item of priority in my list is the restoration of the tax exemption to the income of investors covered by the Indo-Mauritian double taxation treaty. There is no economic justification for the treaty, which reverses the general principle of double taxation treaties that income is taxed in the country of origin. But this is an old treaty, its rationale is political, and the frequent visits of the Prime Minister to Mauritius suggest that the political rationale persists. The mischievous notices that a single income tax officer in Bombay sent foreign investment institutions (FIIs) in 1998 started a long legal process which is still far from ending. In the meanwhile, portfolio investment inflows have virtually stopped. The closed-end funds dedicated to India are closing shop one by one. The ITO’s mischief and the pusillanimity with which the government tackled the issue under the previous finance minister have done considerable harm to foreign investment; the finance minister should give high priority to stopping the damage.

The third is abolition of service tax. It was one of Chidambaram’s silly ideas. The idea was to have an excise on services parallel to the excise on manufactures. Both are outdated. Manufacturing is impossible to define; attempts to define it have led to voluminous court verdicts which have left it ever more obscure. The original idea of a manufacture was something like a matchbox or a bucket – an easily identifiable object with a fixed price, which would bear a fixed excise. Product differentiation multiplies the number of products a manufacturer makes and the number of excise rates for him; for some equipment manufacturers, every object produced may be different. The degree of processing embodied in a product can vary enormously: a manufacturer may produce something from scratch, or may just paint and polish a finished product. The greater the specialization and the less the integration amongst manufacturers, the greater the risk that a product will pay tax a number of times. Services are even more differentiated; every job done for a client by an advertising agency is different. To get away from these insoluble difficulties, value added tax was invented. Now that we have it, it is high time to abolish both the excise and the service tax.

The fourth is the abolition of the minimum alternative tax, another of Chidambaram’s follies. As I explained in an earlier article, most companies pay less than the maximum tax on their profits in subsequent years because of incompletely written off depreciation on assets bought in previous years; the spreading of depreciation over years is enjoined by tax authorities themselves. Some of those companies will pay no tax at all. But to say that they are evading tax is an outrage; their low tax burden arises entirely out of fiscal rules. This tax was based on ignorance of elementary accounting; it should never have been introduced, and the earlier it is consigned to a dustbin, the better.

The fifth is the abolition of import duty on as many goods as possible. This is not so radical as it sounds. If something is being exported, its domestic price is obviously lower than the price abroad, and it needs no import protection. All raw materials should bear the lowest possible duty, and all of them which are not produced in the country should be duty-free. Anything whose domestic price is lower than the international price should be free of duty. If these principles are followed, three-quarters of the tariff items will bear no tariff at all. And once they are freed of duty, exporters who import them will need no advance licences or duty drawbacks; an important barrier to exports, which generates much corruption, will fall away.

The sixth is the reduction of the number of import duties to two, one of which should cover 90 per cent of the dutiable items. The exact level of duties does not matter; reduction of duties is important, but not that important. Far more important is the levying of the same duty on as many goods as possible, so that the customs cannot hold up imports in the name of classification disputes.

My final plea is that revenue targets being given to tax officers must be abolished; they must be told that there are no targets, and that they must tax strictly according to the law. Revenue targets lead to overcollection in the last quarter matched by refunds in the next; they distort and falsify revenue. Worse, they lead to considerable harassment of taxpayers, which some of them no doubt cope with by bribing. Target setting should be replaced by better intelligence on production and income trends of taxpayers; brute force should be replaced by some economics.