Why the draft DTC is underwhelming; it's best to wait for a new one under next govt

The move to create a long-term direct taxes code (DTC) has seen so many revisions and contortions over the last few years that it seems almost pointless. Under P Chidambaram in UPA-1, the code looked liberal and simpler. Under Pranab Mukherjee, who inherited a worsening fisc, some of the generous exemption provisions were rolled back. Now we are seeing the third or fourth avatar of the DTC and it is not looking too much better.

In any case, it is not clear why Chidambaram chose to put out the DTC in the public domain on the eve of an election. Unless it is to show a lot of work is being done. Chidambaram surely will have no say in its implementation. The new government will have its own approach to DTC.

The purpose of having a DTC is to make the government’s approach to direct tax policy crystal clear, stable and predictable so that there is no need for year-to-year tax changes through the budget.

This means it ought to put out the broad principles of taxation rather than get into specifics about whether the tax-free limit should be raised from Rs 2 lakh to Rs 3 lakh, or whether wealth tax should be 1 percent or 0.25 percent, or whether those receiving more than Rs 1 crore by way of dividends should pay 10 percent more dividend distribution tax. (To read the main features of the draft DTC put out yesterday by the government, read here, here and here ).

A principles-based direct taxes code would be dynamic, simple, reasonable, efficient and self-correcting through business cycles even while eliminating the scope for evasion.

While one can argue what these principles should be, broadly speaking they should meet the basic tests of equity, fairness and trust from a socio-economic perspective.

Take income-tax for individuals. The current structure is complicated and iniquitous, with annual revisions of basic exemptions, several investment-linked tax deductions, special deductions for housing EMIs and medical expenses, and so on. Moreover, the tax adds on a surcharge and cess when all three could theoretically be combined into one simple rate of tax.

A principles-based simple DTC on individual taxes would have the following features.

1. A small number of slabs. The current slabs of 10, 20 and 30 percent are fine. There is no need to add a 35 percent super-rich tax rate, as proposed by the DTC. The rich can be taxed by other means.

2. Surcharge and cess can and should be eliminated.

3. Instead of raising basic exemptions every year, there should be an automatic inflation-linked basic exemption, as proposed by Parliament’s standing committee of finance. But this is precisely what Chidambaram’s finance ministry has rejected.

4. Instead of 15-20 deductions (insurance premia, home loan principal repayments, ELSS investments, PF, NPS, NSCs, etc), which anyway have a Rs 1 lakh overall limit, it would have been simpler if the exemptions had been eliminated altogether and the basic exemption level raised by Rs 1 lakh. The current basic exemption of Rs 2 lakh could thus have been raised to Rs 3 lakh and linked to inflation for future changes. By keeping exemptions for this and that, the government ends up distorting the flow of savings to avenues that are related only to tax savings.

5. Instead of taxing dividends at two rates for those earning Rs 1 crore and under and those earning more than that, the simpler thing would have been to eliminate the dividend distribution tax altogether and tax dividends at the individual’s personal tax bracket. This way the rich would be automatically taxed higher. In case there is fear of evasion, it would be a simple thing to introduce tax deduction at source for dividends paid to anyone above a certain limit - says Rs 50,000 or Rs 1 lakh a year.

6. For housing EMIs, it would be best to make the deduction available only for the first house. Second homes should receive no tax benefit.

Next, look at equity.

A principles-based tax system would tax wealth and inheritance to make the rich pay more. Apart from a progressive personal tax structure, there needs to be a tax on wealth to promote inter-generational equity.

This calls not only for an annual tax on wealth, but also on inheritance. Here are two simple proposals:

2. The wealth tax should be low and include all assets, including financial and physical assets beyond one residential house. The threshold limit for wealth tax could be around Rs 5-10 crore, above which the tax could be 0.25 percent per year. The DTC proposes this figure, but for thresholds above Rs 50 crore. The threshold is simply too high; it needs to be lowered. A threshold of Rs 10 crore is more than reasonable, but it should be indexed to inflation.

3. Estate duty needs to be substantial and stiff - with some loopholes for genuine charitable trusts. In the US, estate duties reduce inherited wealth over the generations, and the duty tends to high - currently around 40 percent. India could easily start with a 25 percent estate tax, unless the money is donated to genuine charities. Full exemptions can be given for inheritances below Rs 50 crore, and this level should be indexed.

Last, corporation taxes.

The principles governing corporation taxes should be similar to those for individual income taxes: simple and without too many exemptions, though this is tougher since governments tend to give exemptions to push companies to invest in areas they do not want to go or for exports or some other “good cause”..

The central principle to follow is to reduce the number of exemptions to the minimum. Those that are unavoidable should be given one-time subsidies or tax credits without changing the basic tax rate.