Budget 2014-15: Why income from capital must be taxed more

By Rajiv Shastri

Taxation has become a well debated topic in recent months, brought to the limelight by a disruptive proposal from the Arthakranti think-tank. Now, the adviser to the Union Finance Minister, Parthasarathi Shome, has weighed in, favouring a reduction in the corporate tax rate and an increase in the income tax rate for the higher income brackets. More than anything, this is a sign of how strong the current narrative on ‘fair’ taxation is. The fact that this narrative is completely flawed is conveniently ignored.

In an earlier column in Business Standard,  I had written about how, in an apparent rejection of economic realities, our tax regime promotes inequality by granting preferred treatment to capital income over income from labour. Recapping the basic argument, all income can be divided into two broad categories; labour income and capital income. The initial creation of capital happens only through saved labour income. Once created, capital can either be invested to generate capital income or consumed and extinguished.

Typically, wage earners who earn all their income from labour occupy the lowest end of a nation’s income distribution while capital owners, who earn all their income from invested capital, occupy the highest extreme. The middle classes derive their income from a combination of labour and capital income, with the share of the latter increasing with income.

Consequently, a tax regime which taxes wage earners at a rate higher than capital owners is not only regressive, but inherently perverse. Firstly, by pre-empting a large portion of labour income, it reduces the creation of fresh capital and prevents wage earners from becoming capital owners. Secondly, by allowing existing capital owners to retain a larger portion of their income compared to wage earners, it perpetuates inequality.

The perversity of such a system is immediately apparent. With the effective tax rate falling as the share of capital income in total income increases, the wealthiest who typically derive almost all their income from capital pay the lowest rate of tax. So, not only do those at the top of the income distribution earn significantly more, they also retain a larger portion of their earnings, increasing the share of capital in their hands as time progresses. Sounds familiar?

Merely 42,800 people declare an annual income of over Rs. 1 crore in India. Our policymakers lament this fact periodically, but fail to mention that it is their policies that permit scores of those earning more than Rs 1 crore to escape declaring it. With many forms of capital income (dividends, long-term capital gains) exempt from tax, the number of people declaring incomes of more than a crore is a fraction of those earning that amount. How the inequity promoted by these exemptions can be rectified by merely increasing the tax rate for the high income bracket is confounding, to say the least.

As far as a lower rate of corporate tax is concerned, consider this. A corporate entity is essentially a body of capital which hires labour, and other capital, to achieve its ends. Its profit is what it saves after all expenses are charged and, as such, is the return on its owned capital. It is nothing but capital income earned by the corporate in its capacity as a separate and distinct capital owner. There is absolutely no justification for this income to be taxed at a rate lower than the highest rate applicable to labour income.

Moreover, to justify a lower tax rate by claiming that it will promote growth is like allocating free coal blocks to ensure cheap electricity or giving away bandwidth to ensure lower telecom user charges. The fact that these indirect ‘subsidies’ cause more damage than benefit to the overall economy has been proved beyond doubt. Also, the identity of the true beneficiaries of such ‘initiatives’ is a continuing mystery.

To achieve equity and suitability, our tax regime needs to move away from classifying income on the basis of who earns it to classifying it on the basis of how it is earned. Income from labour is the fountainhead of all capital. For true equity to exist, it should be taxed at the lowest possible rate. This will encourage the creation of new capital which is well distributed amongst the population and reduce inequality. Income from existing capital, on the other hand, needs to be taxed and taxed well.

Given the relatively higher mobility and homogeneity of capital, this isn’t a simple task. But should we use this difficulty as an excuse to perpetuate a perversity, or worse still, exacerbate it? Or is it time to rethink our tax regime from the ground up? It is often said that to get the right answer, one needs to ask the right question. It is imperative that our policy makers start asking the right questions.

The author is Director & Business Head Portfolio Management Services & Product, Pramerica Asset Managers.

Twitter handle  @rajivshastri.