Why Chidambaram can't do a Warren Buffett in budget 2013

The legendary investor Warren Buffett wrote an editorial in the New York Times some time in August 2011 where he made an interesting point. In 2010, his income and payroll taxes came to around $6.94 million. While that might sound like a lot of money, but Buffett had paid taxes at a rate of only 17.4 percent of his income. This was lower than any of the 20 other people who worked in Buffett’s office in Omaha, Nebraska. The tax burdens of his 20 employees amounted to anywhere between 33-41 percent and it averaged around 36 percent. So Buffett was paying $17.4 as tax for every $100 that he earned. On the other hand, his employees were paying more than double tax, at  $36 on an average, for every $100 that they earned. Of course, Buffett felt that was not right. But why was this the case? This was primarily because Buffett’s employees were paying tax on the salary that they earned by working for Buffett. Buffett was making money primarily as long-term capital gains on selling shares and he was paying tax on that. The tax rate on income from salary was much higher than the tax rate on income from long-term capital gains made on selling shares. This benefited rich Americans like Buffett. The richest 10 percent of the Americans own 80 percent of the stocks listed on the New York Stock Exchange as well as Nasdaq. Buffett wants this to be set right by making the rich pay higher taxes. In India, there has been talk about making the rich pay higher taxes as well. C Rangarajan, a former Reserve Bank Governor, and an economist who is known to be close to both Prime Minister Manmohan Singh and Finance Minister P Chidambaram, had remarked in January earlier this year: “We need to raise more revenues and the people with larger incomes must be willing to contribute more.” [caption id=“attachment_633866” align=“alignleft” width=“380”] Chidambaram will have to keep the foreigners and the stock market investors happy to ensure that the stock market keeps rising. Meanwhile, the rich will continued to be taxed at lower effective rates.[/caption] Chidambaram himself has advocated this school of thought when he said “We should consider the argument whether the very rich should be asked to pay a little more on some occasions.” So does taxing the rich make sense? It is not a simple yes or no answer. Allow me to explain. Like in the case of the United States, even in India different kinds of incomes are taxed at different rates. Income from salary is taxed at the marginal rate of 10/20/30 percent whereas long-term capital gains from selling shares/equity mutual funds is tax-free. Short-term capital gains from selling shares/equity mutual funds is taxed at 15 percent. Interest earned on bank fixed deposits and savings accounts is taxed at your marginal rate of tax - which means 10/20/10 percent. So is the income earned from post office savings schemes and the senior citizens’ savings scheme. In comparison, dividends received from shares is tax-free in the hands of the investor. Long-term capital gains on debt mutual funds are taxed at 10 percent without indexation or 20 percent with indexation, whichever is lower. Indexation essentially takes inflation into account while calculating the cost of purchase. Let us say an investor buys a debt mutual fund unit at a price of Rs 100. A little over a year later he sells it at Rs 110. Let us say the inflation during the course of that year was 8 percent. Hence, his indexed cost of purchase will be Rs 108 (Rs 100 + 8 percent of Rs 100). In this case, the capital gains would be Rs 2 (Rs 110 – Rs 108) and he would end up paying a tax of 40 paise (i.e. 20 percent of Rs 2). Hence, a 40 paise tax is paid on capital gains or an income of Rs 10 (Rs 110 – Rs 100), meaning an effective income tax rate of 4 percent (40 paise expressed as a percentage of Rs 10). In case an individual had invested Rs 100 in a fixed deposit paying an interest of 10 percent, he would have earned Rs 10 at the end of the year as interest from it. On this he would have had to pay a minimum tax of 10 percent (assuming he earns enough to fall in a tax bracket) because interest earned from a fixed deposit is taxed at the marginal rate of income tax. Whereas, as we saw, in case of a debt mutual fund the effective rate of income tax came to around 4 percent. Along similar lines, long-term capital gains from the sale of property is taxed at 20 percent post indexation. So the effective rate of tax is much lower in the case of capital gains made on selling property as well. In fact, even this tax need not be paid if one buys capital gains bonds or another property within a certain timeframe. And given that a large portion of property transactions are in black, the effective rate of income tax comes out even lower. The point I am trying to make is that the modes of income for the rich like dividends, capital gains from selling shares, equity mutual funds, debt mutual funds or property for that matter are taxed at lower effective income tax rates, in comparison to the modes of investment of the aam aadmi (except in the case of debt mutual funds). The purported logic, at least in the case of long-term capital gains from shares being tax-free, is that it will encourage the so-called retail investor/small investor to invest in the stock market and thus help entrepreneurs raise capital for their businesses. But that, as we all know, has not really happened. And essentially this regulation has been helping those who already have a lot of money. What I fail to understand further is why should investing in a debt mutual fund like a fixed maturity plan (which works precisely like a fixed deposit does and matures on a given day) be more beneficial tax-wise vis-a-vis investing in a fixed deposit? As we saw in the earlier example, a fixed deposit investor pays a minimum tax at the rate of 10 percent on the interest earned. He could even pay an income tax as high as 30 percent . On the other hand, a debt mutual fund investor pays an effective tax at the rate of 4 percent, irrespective of which marginal rate of income tax he falls under. Why should that be the case? I think we need to move towards a more equitable income tax structure where various modes of income, at least those earned through investing, should be taxed at the same rate. For starters, indexation benefits which are currently available on debt mutual funds and sale of property should also be available when calculating the tax on interest earned on fixed deposits and savings accounts. Inflation doesn’t only impact those investing in debt mutual funds and property; it also impacts those who invest in bank fixed deposits and savings accounts. Further, long-term capital gains on selling shares/equity mutual funds should be taxed at marginal rates with indexation benefits being taken into account. That would make the tax system more equitable than from what it currently is. It would also result in the rich paying more tax without introducing a higher tax rate or a surcharge of 10 percent on the highest marginal rate of 30 percent (which would mean an effective rate of 33 percent), as is being suggested currently. Several experts are against this move and I partly agree with them. As an article in the India Today points out, “Economist Surjit S Bhalla argues that there is no real rationale for taxing the top income segment any further. Bhalla uses official data to show that the top 1.3 percent of income taxpayers in India already account for 63 percent of total personal tax revenue. In comparison, in the US, the top 1 percent of taxpayers contribute just 37 percent of total income taxes.” That’s a fair point against higher taxes for the rich. But what we really need to know is what is the effective rate of income tax being paid by the rich? Is the situation similar to Buffett’s America, where Buffett pays an effective income tax of 17.4 percent whereas his employees pay an average tax of 36 percent? Only the Income Tax department can answer that. Having said that, I don’t see India moving towards a more equitable income tax structure. In order to do that, long-term capital gains on selling stocks, which is currently at zero percent, would have to be done away with. And that would mean these gains should be taxed in a similar way as debt mutual funds/property currently are. Hence, stock market investors would end up paying some income tax. And that, as we have seen in the past, is something they don’t like. Any attempt to tax them is met by mass selling and the stock market falling. A falling stock market would mean that dollars being brought in by foreign investors will stop coming or slow down. When foreign investors bring dollars, they sell those dollars to buy rupees, which they use to invest in the stock market in India. This perks up the demand for the rupee, leading to its appreciation against the dollar. A stronger rupee would mean a lower oil import bill. Oil is bought and sold internationally in dollars. If oil is worth $110 per barrel, and one dollar is worth Rs 55, it means India pays Rs 6,050 per barrel ($110 x Rs 55) of oil. If one dollar is worth Rs 50, it means India pays a lower Rs 5,500 per barrel ($110 x Rs 50) of oil. Lower oil imports would help control our current account deficit which is at record levels. It would also help control our fiscal deficit as the government forces the oil marketing companies to sell products like kerosene, cooking gas and diesel at a loss and then compensates them for the loss. It would also help oil companies control their petrol losses. This is a dynamic that Chidambaram cannot ignore. He will have to keep the foreigners and the stock market investors happy to ensure that the stock market keeps rising. Meanwhile, the rich will continued to be taxed at lower effective rates. Vivek Kaul is a writer. He can be reached at vivek.kaul@gmail.com