Are we killing the golden goose?

DIRECT TAX

Chambers and industry are wondering what new surprises could spring up in the 2007 Budget.

Though the tax collection figures must have cheered the finance ministry, corporate India is keenly watching if it would resonate in moderate tax rates, and also lead to continuation of tax holidays.

Historically, our tax holiday agenda has targeted development of particular areas, specific industries, infrastructure and garnering foreign exchange reserves.

For the past two decades, successive governments have expanded the coverage and tweaked certain incentives. But lately, the debate on why and when these tax holidays should be phased out has gained momentum.

India's experience on tax incentives is difficult to measure since there are no agreed yardsticks to do so. Whereas, on grounds of equitable development of underdeveloped areas, there is a case to incentivise industries setting up units in backward locations, equally important is the energy security.

In the 2006 budget, the finance minister extended tax sops to the power sector, given the sheer gap between demand and supply.

Fiscal sustainability vs fiscal discipline: Recommendations from most economists and successive tax reforms committees have guided the thinking of policy makers in North Block and there is a general consensus that multitude of tax sops has taken a toll on the fiscal deficit.

In 2002, the government appointed Kelkar Task Force, which initially recommended one-time removal of all tax incentives. Though Dr Kelkar's recommendations did not find favour with the industry and chambers, the government did adopt the committee's recommendations, though in a piecemeal fashion.

The past few years' budgets have reflected the thinking of the Kelkar panel by way of gradual phasing out of export incentives, non-extension of holidays to specified infrastructure projects and more importantly, 2009, sunset clause for the software technology park scheme.

The Year 2004 saw operationalisation of the Fiscal Responsibility and Budget Management Act (FRBM), passed in 2003 after three years of parliamentary debate. The Act commits Parliament to a programme of medium term fiscal consolidation.

Given the targets for reduction of fiscal and revenue deficit, the easier path that the finance minister can walk is by drawing strength from the FRBM Act to counter any demand for additional expenditure or tax relief.

It is debatable whether the minister should walk the tougher path of curtailing expenditure or the path of moderating tax rates, including articulating a road map for tax sops. Realistically, given the stringency of the FRBM Act, coupled with the challenges posed by coalition politics, the case of continuing tax incentives is weakened.

World over, tax reforms are influenced by economic theory, evolving economic structure, exigencies of practical tax administration and lessons of experience.

The straight jacketed approach that all tax holidays irrespective of their origin, experience and outcome should be discontinued, belies rationale and logic. Most economists believe that exemptions and tax preferences should be limited, not eliminated.

One of the reasons for opposing tax incentives, echoed by the World Bank and International Monetary Fund (IMF), is that they should not be used for incentivising investment since it invites tax avoidance through indefinite extension of holidays via creative re-designation of existing investment as new investment.

So what does future has in store? The 2007 Budget is expected to throw light on future of tax holidays. With the government bound by FRBM targets, it finds itself in a tight spot; some pessimists believe that the axe may fall on a few more tax incentives.

North Block's consistent position seems to suggest that tax incentives approaching their sunset are unlikely to be extended, though views from other quarters of the government suggest otherwise. It is fair to conclude that this is an ongoing debate.

Given the demographics and current growth momentum, India need not offer tax sops for investment. But at the same time, one cannot lose sight of the fact that for growth to continue its upward march, infusion of investments in key sectors such as infrastructure, energy and software must be encouraged.

An effective tax rate of almost 47 per cent, comprising of over 33 per cent corporate tax and 14 per cent dividend distribution tax makes us as one of the high taxed nations, if not the highest.

The obvious question weighing in the minds of investors would be "" Should we continue growing in India or are there alternatives? This does not take into consideration onerous compliance requirements as a result of complex tax administration procedures.

A question the government should pose itself is "" Is it imperative to provide tax breaks since sans such incentives, the cost of doing business in India could be prohibitive, besides the competitive disadvantage?

It is strongly advocated that emphasis should be on providing incentives to long-term players whose participation is essential to the country's infrastructure development needs, employment generation and sectors that require extensive capital.

Shouldn't we be measuring the economic development attributable to growth in the services sector viz, IT/ITES, before denying any further benefit? Should we assess the potential of this budding industry rather than mixing it up with large macro-economic issues?

An important objective that the policymakers should be focusing on is a plan to simplify complexities relating to tax holiday claims and removal of ambiguities, which is leading to protracted litigation.

We need a simple tax system to administer tax incentives; one which is effective with strong reliance on modern systems and technology for information gathering, collation and analysis, topped with transparent procedures for penalties, appeals and implementation of new transfer pricing regulations.

In conclusion, tax incentives have advocates for and against, but, perhaps, the truth lies somewhere in the middle "" in evolving a tax policy with an eye on fiscal prudence and need for capital infusion.

No one denies that misuse of tax holidays leads to a greater loss to the economy than its utilisation by deserving taxpayers.

The focus of the government should be on tightening the leash on tax holidays, reconsidering sunset clause for deserving industries and ensuring transparency. The idea is to device a mechanism to gauge benefits to the economy and weigh them against apparent loss of revenue on a case to case basis for each sector staking.

In the final analysis, given the significant increase in tax collection, could the FM have had a better opportunity to relook the roadmap for tax holiday or, as Dr Shankar Acharya has said in his essays on Macro Economic Policy and Growth in India, his budget can draw strength from the FRBM Act and pointing to the benchmarks, the FM says, "Look, I would have liked to provide more money for education, but I can't without breaching the FRBM targets."

It's time to prove that theory wrong.

The author is a partner with BMR & Associates and views are personal