Globally, a lot of the research on inequality focuses on its economic and socio-political consequences. However, a growing body of research explores its causes, especially those exclusively in government control to determine the role of policy. Much of this research concludes that tax policies over recent decades have played an extremely significant role in promoting inequality, with the trend of granting preferential treatment to capital income bearing primary responsibility. And the reasons aren't difficult to understand.
Income is derived primarily from two sources: labour and capital. The initial creation of capital happens only through saved labour income. Once created, capital can be either invested to generate additional income or consumed. Typically, those at the very lowest level of income distribution derive all their income from labour, while those at the very highest derive almost all of it from capital. Those in between typically derive a larger share of income from capital as income levels increase.
Among those who earn capital income, those with the least capital typically invest in safe fixed-income instruments like bank deposits. As savings rise, increased risk-bearing capacity allows some investment in riskier instruments such as equities, real estate and commodities, with allocation to riskier instruments increasing with wealth.
Labour income is subject to the highest tax under the Indian tax regime, not only because of the tax rates but the manner in which taxable income is calculated. Labour income is taxed on the total income earned, barring a few exemptions and allowances, none of which keep pace with either the time or expenses related to earning the income. In contrast, capital income is taxed on the profit or savings after providing for all related expenses. This is also true for corporate entities, which are taxed on residual income after all expenses are provided for.
Moreover, income from safe capital investments like bank deposits is almost fully taxed at a high rate, barring a few allowances. More importantly, interest income is not adjusted for inflation, levying a tax on even the portion of interest required to prevent the inflationary degradation of the principal. However, income from riskier capital investments is either completely exempt or taxed lightly.
Based on the typical income/wealth distribution and investment framework described above, this tax regime is perfectly perverse. It ensures that tax rates actually decrease with rising income. Apart from being inherently regressive, the long-term impact of such a regime on inequality is spectacular.
It is well established that the rich save a larger portion of their income. A lower tax rate increases this savings potential further, allowing them to add to their capital at a much faster pace and deploy these savings once again to earn additional income. This cycle progressively worsens both income and wealth inequality.
While it is undeniable that this regime is nonsensical, it is also true that taxing capital income efficiently is confounding due to its mobility. Double tax avoidance agreements (DTAAs) complicate matters further with capital typically seeking the lowest-cost destination with relative ease.
The easy way to sidestep these challenges is to structure an indirect tax on capital transactions to replace direct taxes. Following this thought, India introduced a securities transactions tax (STT) in 2004. However, STT collections have proved to be disappointing, averaging less than 0.10 per cent of GDP since its introduction. In April-December 2013, STT collections totalled just Rs 3,427 crore or 0.04 per cent of GDP. The popular narrative hails STT as a measure that virtually eliminates tax evasion since it applies to all trades and is collected institutionally. However, considering the dissonance between the tax it purports to replace and achieved collections, one cannot help wondering whether STT eliminates evasion or legalises it. Also, using potential tax avoidance as an excuse for accepting low collections rings hollow in the connected age, especially in markets as institutionalised as the financial markets.
The more difficult, but significantly more rewarding, approach is to introduce fundamental changes to the manner in which we approach taxes. The primary change will be to move from classifying income on the basis of who earns it to classifying it on the basis of how it is earned - from labour or capital. With this founding thought, taxation could follow basic rules. First, income from labour should be either exempted altogether or taxed at a nominal rate. This will allow low-income earners the opportunity to save and create capital, increasing the dispersion of capital and eventually widening the tax base. Second, all income from capital should be taxed at a significantly high rate after adjusting for inflation. For increased efficiency, inflation adjustment should be at monthly rests instead of the current annual format. Third, as with equities, all capital investments, including real estate, should be held only in dematerialised form. Fourth, tax should be levied on the profit for each transaction.
For this to work, information sharing between banks and depository participants will need to be enhanced to capture trade-level information accurately. Tax should be deducted by banks based on information provided by depository participants. Similarly, all deposit-taking entities should subject inflation-indexed interest earnings to tax.
Selective exemptions may be granted to senior citizens and adjustments allowed for trade consolidation. In addition, foreign investors may be given the benefit of applicable DTAAs. However, all exemptions and adjustments should be structured as refunds claimed by filing the appropriate return.
This tax treatment should be applicable to all taxpayers with corporate entities essentially treated as bodies of capital and their earnings treated as capital income. All distribution of income from corporate entities to shareholders should be fully taxed as capital income as well. The popular narrative that seeks to condemn this as double taxation, by extending the logic applicable to proprietorship and partnership firms, is a half truth that should be consigned to the financial dustbin at the earliest. A corporate entity is a legal entity distinct from its shareholders. As such, its identity as a capital owner is also distinct from its shareholders and both need to be taxed fully in an equitable regime. Nothing highlights this difference in organisational forms better than the liability of capital contributors in case of bankruptcy. A proprietorship or partnership firm cannot be bankrupt if even one of its capital contributors is solvent. A company can. Shareholders who enjoy the benefits of a limited liability should be prepared to subject themselves to commensurate logical taxation as well.
It is clear that our current tax system is perverse and cannot be allowed to continue. It is equally clear that alternatives exist. At the current level of inequality, India has a choice. We can either correct the major policy contributor to it or face the socio-political consequences, signs of which are already visible. One can only hope that we choose wisely.
The writer is Director & Business Head Portfolio Management Services & Product, Pramerica Asset Managers
These views are personal