Chidu's volte-face: From tax-free buffet to Buffett Tax

Palaniappan Chidambaram’s dream job is obviously his previous one. He made his name as the co-architect of liberalisation along with Manmohan Singh in the early 1990s. During the United Front government, he presented a “Dream Budget” which later turned out to be a nightmare for the economy, but it was noted for its bold strokes on tax reforms. The dividend distribution tax (DDT) is an artifact from that era.

As finance minister till end-2008 in UPA-1, all he may be remembered for is his flip-flop on 2G spectrum auctions, but history will be kinder. Among other things, he was the progenitor of several innovative - though flawed - tax proposals. These include the banking cash transaction tax (BCTT), the securities transaction tax (STT) and the fringe benefits tax (FBT). He also abolished long-term capital gains tax.

Barring STT and DDT, which are now widely accepted, the FBT and BCTT were widely hated and were subsequently legislated out of existence.

But despite being kept at an arm’s length from his favourite ministry, Chidambaram has not stopped ruminating on its challenges. He now thinks the budget needs resources, and the rich are the obvious ones to pay for it.

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Taxing the rich has become the theme-song of governments all over the west in the post-Lehman age of huge government debts and jobless growth. The Economist ran a cover story on ‘Hunting the rich’. President Obama has also made some noises on taxing the rich after ace investor Warren Buffett said he felt guilty about paying less tax than his secretary.

Is India ready for a Buffett tax on the rich?

[caption id=“attachment_95475” align=“alignleft” width=“380” caption=“The reason why the rich pay less tax is that they get most of their incomes from dividends and capital gains - not salaries. AFP”]  [/caption]

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Speaking at a Delhi event on Wednesday, Chidambaram said: “We must raise the tax revenue to defend (the expected aggregate decline of resources). I know many people won’t like this. But I think, I can summon the courage to make the statement… you must be prepared to pay higher tax rates, especially the rich must be prepared to pay higher tax.”

As a broad statement of principle, no one can quarrel with this. However, one needs to understand what taxing the rich means - and whether it will do more harm than good.

Let’s first get rid of a few illusions. It is not that the rich pay less tax. They pay much, much more than the poor. When Buffett says he pays less than his secretary, he is not talking about the absolute amount of taxes paid, but taxes paid as a percentage of income. Also, one must question why Buffett - who accumulated all his wealth by canny investing and avoidance of taxes - should at the fag end of his career fret about not paying enough to the exchequer.

The reason why the rich pay less tax is that they get most of their incomes from dividends and capital gains - not salaries. Buffett’s secretary earns a salary while the old man gets his income from dividends and capital appreciation.

It’s the same in India, as Firstpost pointed out in a recent report. So if Chidambaram wants to get the rich to pay more he has to close the loopholes he himself created for them.

The two main culprits are the dividend distribution tax (DDT), which allows promoters to earn tax-free dividends (the DDT is paid by their companies, not them), tax-free long-term capital gains, and low taxation of (15 percent) short-term capital gains.

Moreover, the rich can avoid almost all taxes since they hold their wealth through companies and trusts - not as individuals. Companies can set off incomes against expenses and business losses, further reducing the effective rate of tax on the rich.

Another avenue which helps the rich get away with paying lower taxes is the iniquitous value-added tax. When every good - whether it is bought by the rich or the poor or the middle classes - is going to be taxed at the same rate, it is by definition unfair. The small bar of soap bought by the aam aadmi is taxed at the same rate as the perfume bought by the rich. The Maruti petrol car owner pays more in fuel taxes than the rich diesel Mercedes owner.

Most of these distortions were brought in by Chidambaram himself. He was the author of the DDT and the abolition of tax on long-term capital gains was his signal achievement.

The differential treatment of debt is also a problem. For a businessman, debt is a cost that can be tax-deductible, while capital gains come tax-free. So businessmen can use debt to, first, reduce their tax liabilities on the taxable areas of their incomes and then not pay tax on dividends and capital gains. They get a double-benefit.

Chidambaram admits that he was the “finance minister who slashed your tax rates”, but the fact is most of the distortions also come from deliberate policies intended to favour the aam aadmi. The decision to keep diesel prices low was intended to keep inflation down, but it helps the rich the most.

Sure, some of these tax breaks - and especially the dividend and capital gains taxes - can be rationalised to exclude the rich from their benefits.

But whether a wholesale soak-the-rich policy will earn the exchequer more revenue is debatable. Reason: real growth in tax revenues comes from profitable business growth, not redistribution of existing incomes of the rich.

The problem is UPA-1 and UPA-2 are planning to inflict new costs on businesses - higher interest rates due to inflation, higher cost of land and ores due to policies intended to favour farmers and tribals, et al. When core business profitability is going to head south due to these macro policies, trying to tax their personal incomes is not going to yield much.

It will, in fact, have the opposite effect. The rich will shift their assets abroad to keep them away from the taxman.

Chidambaram earned his spurs as a tax-cutter. Reinventing himself as a tax-raiser is not going to do him any good just as it has not done reformer Manmohan Singh any good by shying away from economic reforms as PM.

The irony is this: Chidambaram was the man who invited the rich to his tax-free buffet. He now wants to hit them with a Buffett tax.