Customs duties used to be an important source of revenue, but they interfered with cross-border activities and had to go. Then came the problem of indirect taxes. If India has a 20 per cent excise on domestic steel, fairness requires that imported steel have a 20 per cent excise. What about exports? Suppose Indian steel suffers a 20 per cent excise. If steel is untaxed in the UK, the Indian company is uncompetitive against local (untaxed) steel in the UK.
The solution lay in two steps: first, a shift to the value-added tax (VAT), and second in "zero rating of exports". VAT made it possible to track the comprehensive incidence of domestic taxes in the supply chain. Steel value-added is taxed, and crankshaft value-added is taxed, so we can identify the full burden of domestic taxation suffered by an Indian crankshaft company. Under 'zero rating of exports', foreign buyers are refunded this full tax burden.
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This was a remarkable step for the political system. Zero rating of VAT was demonised; it was called "subsidising foreign buyers" or "having a non-level playing field between local buyers and foreign buyers". Left economists were up in arms against refunding Indian taxes paid by a French buyer of Indian steel.
The rule of tax policy in the age of globalisation is: You do not tax non-residents. If we try to tax French buyers of Indian steel, they will take their business elsewhere. Hence, India must refund all taxes to non-resident buyers of Indian goods and services.
We can tax our residents as we please. When French steel comes into India, we can tax as we like, as the buyer is a resident and has no alternatives. When French steel is imported into India, the Indian buyer is refunded the embedded French taxes (as France practices residence-based taxation). At the entry point in India, the Indian authorities practice residence-based taxation, and impose the Indian VAT rate on the imported steel. This is termed "VAT on imports".
Some countries have political constraints which hamper international trade. As an example, India and Pakistan do not play by the rules with each other. This creates a need for 'entrepot centres'. Indian goods get exported to Dubai, as the India-Dubai relationship plays by the rules. Goods get exported from Dubai to Pakistan, as the Dubai-Pakistan relationship plays by the rules.
When countries do not play by the rules of globalisation, rationality is enhanced by routing through entrepot centres. This complicates the work of policemen, tax inspectors, etc, who have to work harder at figuring out what is going on. It creates opportunities for tax evasion and crime. That said, entrepot centres are the junction boxes that deepen globalisation for the countries that do not play by the rules. They reduce the harm suffered by countries who make mistakes in tax policy.
These ideas apply identically to capital flows and international finance. Singapore makes Nifty futures and the UK makes Nifty futures. If Singapore imposes even a tiny tax upon a Japanese buyer, the order will go to the UK. The solution is residence-based taxation. Each country taxes the global income of its residents, and exempts non-residents.
Suppose the risk associated with an Indian government bond requires a six per cent interest rate in the world market. Suppose India tries to tax non-residents and demands a tax from them of two percentage points.
This simply drives up the interest rate for Indian government bonds up to eight per cent. Everyone suffers administrative overhead: Indian government bonds pay eight per cent, and two percentage points are sent back to India as taxes. A five-year bond would have a 10 per cent lower price when the interest rate goes up from six per cent to eight per cent. When India taxes non-residents, they attach lower values to Indian assets.
OECD (Organisation for Economic Co-operation and Development) countries and mature emerging markets understand these rules and play by them. There are some countries, eg India, who do not. We hanker after source-based taxation.
This gives rise to entrepot trading. Some business transactions are routed through Panama as Panama has good tax treaties with certain countries. Certain business transactions were routed through Mauritius as it had a good tax treaty with India.
A Japanese investor who sends a Nifty futures trade to Singapore, London or Chicago faces no taxation there, as all mature countries play by the rules. When India tries to tax this activity, this business moves away. This harms the export revenues of Indian services firms. This damage was reduced by the presence of the Mauritius treaty. The damage was not eliminated by the Mauritius route, as the non-resident was not refunded the STT.
Again, when countries do not play by the rules of globalisation, rationality is enhanced by routing through entrepot centres. This complicates the work of policemen, tax inspectors, etc, who have to work harder at figuring out what is going on. It creates opportunities for tax evasion and crime. That said, entrepot centres are the junction boxes that deepen globalisation for the countries that do not play by the rules. They reduce the harm suffered by countries who make mistakes in tax policy.
The enforcers complain about entrepot centres as the increased complexity of business transactions makes their life more difficult. We should ignore their pleas. It is only in a police state that a policeman's job is easy. The way to eliminate these problems is to modernise our tax policy. We did not stop gold smuggling by having more draconian enforcement. We stopped it by living by the rules of globalisation: by removing the customs duty.
These principles of tax policy are valuable when thinking about an array of issues including the flight of financial activity out of India, 'permanent establishment', taxation of FIIs, tax treaties, Panama, STT on FII.
The writer is a professor at National Institute of Public Finance and Policy, New Delhi