Tax Policy: Simplify, Simplify

Leaving small business and self-employeds out of the tax net imposes additional burdens on those who actually pay
tax structure in India has come a long way. In the initial years, the tax system was employed to mobilise resources for the Plans. Economic disincentives on work, savings and investment mattered less and the need to garner revenues for financing public sector dominated, heavy industry based import substituting industrialisation was paramount. The tax system also had to bring about a socialistic pattern of society. Thus, in 1973-74, the marginal tax rate of personal income tax was raised to 97.75 per cent and along with the wealth tax, the rate was more than 100 percent!
In the process, the tax policy created a dishonest society: people either reduced or simply concealed their incomes. Tax evasion was easy because a large part of the economy was unorganised, income from agriculture was exempt and information system was quite inaccurate.
In 1985-86, personal income taxation was simplified with the number of brackets reduced from eight to four and marginal tax rate reduced to 50 per cent. In 1991, the number of tax brackets was reduced to three with tax rates levied at 20, 30 and 40 per cent. The Union Budget for 1997-98 reduced the rates further to 10, 20 and 30 per cent. Since 2005-06, a surcharge of 10 per cent on the payable tax was levied on incomes above Rs 10 lakh.
Despite simplification, a number of problems remain. Comprehensive income tax is not possible in India as agricultural incomes are exempt. Small businesses and self-employeds simply do not pay tax. Leaving them out of the tax net imposes additional burdens on those who pay for, had they been taxed, the tax rate to raise the same amount of revenue would have been lower. Similarly, there are exemptions and preferences for savings, interest incomes and investments in housing and equities. There have also been a lot of flip-flops in the dividend taxation policy. Dividend tax was 20 percent in 2000-01, subsequently reduced to 10 percent in 2001-02 and levied on shareholders. The policy was reversed in 2003-04 with the levy of the tax on the company.
Interestingly since 2002-03, the revenue from income tax has shown a sharp increase. The annual growth rate of revenue from personal and corporate income taxes has averaged to 30 per cent since 2002-03 and the revenue from income tax relative to GDP has increased by 3.5 percentage points. The credit for this must be given to the Tax Information Network that has been put in place by the National Security Depository Ltd.
Comprehensiveness and simplicity should be the goals of the next stage of tax reform. The first involves inclusion of incomes from agriculture. This would require amendment of the Constitution enabling the Central government to levy agricultural income tax. Second, sufficient safeguards are necessary to reduce volatility and associated risks in farm incomes and there must be a loss carry-forward provision while taxing agricultural incomes. Other reforms include minimising tax preferences to some forms of investments as against others to avoid distortions in asset choice. The system of flat rate of tax in countries such as Russia has been successful. In India, it may not be possible to implement such a tax, but it is possible to simplify the structure further by having just two rates: 10 per cent and 20 per cent. In a simple tax system, there is no scope for cesses and surcharges. The States, given concurrent powers to tax, can levy a flat tax rate of 5 per cent on all incomes above the exemption limit.Will this happen in the near future? I doubt it. The farm lobby may not give in to the idea of taxing agricultural incomes. Surely it should be possible to simplify the tax by removing various incentives and preferences and reducing the tax brackets to two. Without various exemptions and preferences (excepting the basic exemption), the tax system will be simple and more comprehensive. Lower rate of tax induces better compliance and promotes higher growth and both will contribute to higher revenue productivity. This should remove the need for cesses and surcharges. Hopefully, future reforms will move in this direction