Executive Director, PricewaterhouseCoopers The Kelkar task force, which recently submitted its report, has laid out a new vision on the broad framework of fiscal policy geared to achieve high-quality growth, to re-jig tax policy to minimise investment pattern distortions and encourage a fresh look at incentive legislation in the fiscal structure and its perceived adverse impact on the tax/GDP ratio.
It has recommended sweeping changes to the current corporate tax regime and suggested the earliest possible phase-out of various tax incentive legislations.
In a global economy, countries compete for investment and investors are constantly evaluating alternative investment destinations both on economic and non-economic considerations. India has traditionally scored well on the non-economic criteria but has lagged in the global investment stakes.
India's tax regime, which allows both federal and local government to collect taxes, presents unique challenges for an investor. It is a considered result of many independent studies that the cumulative impact of India's federal and local levies makes this country a particularly high-tax investment destination. This is without accounting for other systemic inefficiencies such as a rigid labour market, red tape and so on.
In the 1990s, India embarked on a new path of economic progress that sought to make the country an attractive investment destination for private capital. An integral part of the strategy to attract capital was to offer tax holidays over a medium-term period of five to 10 years for investments in export-oriented projects and sunrise areas such as telecom, power and so on.
The economic rationale for such incentive legislation was unquestionable as traditionally, many countries have successfully attracted private capital in designated areas through fiscal incentives.
In the above context, the Kelkar task force seeks to make a preliminary case that promissory estoppel does not operate against the state, meaning that a long-term investor cannot count on stability in the tax regime and certainty of incentives promised while making a large investment decision. Realising the tenuous nature of this argument, the committee goes on to suggest grandfathering as a possible solution.
Implicitly, the committee has recognised that in the new, globalised economy, big-ticket private investment often requires a fiscal stimulus as economists continue to explore the many positive contours of the "multiplier effect" generated by such large investments that catapult growth, income generation and tax revenues in the long run.
In the Indian context, experience suggests that it is an unmistakable fact that original investment, coupled with a stable fiscal policy where commitments are kept and a regulatory environment that is growth-oriented is the best policy cocktail for a cycle of sustainable growth.
One of the arguments cited by the Kelkar task force against tax incentive legislation is that it distorts investment patterns. Though this may be true for some other countries, it is not necessarily true for India. The change in investment pattern that may have been triggered through exemption of export profits is in sectors where India enjoys a competitive advantage vis-à-vis rest of the world.
The second, equally-powerful argument put up by the task force is the loss of revenue argument "" meaning thereby that the government works under a revenue constraint.
The IT sector has in the past when so challenged successfully demonstrated that the value addition in the sector is continually distributed to the various stakeholders "" that is, employees, shareholders, suppliers and so on "" who continue to be taxed and their aggregate contributions to the treasury far exceed any notional loss of revenue through exemption at the corporate level.
Last, but not the least, it is also argued by the Kelkar task force that some of the areas that have been incentivised are precisely the areas where our competitive advantage is so strong that investments would have flowed into the sector with or without tax subsidies. This is a proposition with no easy answers "" currently no authoritative data seems to have been collated on the subject whereby any reliable conclusions can be drawn either way.
It is, therefore, clear that the subtext for an early phase-out of export-linked fiscal incentives may need to be drawn from outside the text of the report. Emerging markets such as India were allowed a 10-year window in the Uruguay round in 1990, to phase out export subsidies that are incompatible with the General Agreement on Tariffs and Trade framework.
The European Union has more than once successfully challenged certain impermissible tax incentives contained in the US income tax code. It, therefore, needs to be considered whether India is safeguarding itself from similar challenges by an early phase-out of the tax incentive regime specially targeted towards export promotion. The Kelkar task force provides us no specific answers but it is difficult to assume otherwise.
Pradeep Dinodia
Chairman of Taxation Committee, FICCI
The terms of reference of the Kelkar task force on the implementation of the Fiscal Responsibility and Management Act (FRBM) were to draw up a medium-term framework to eliminate the fiscal deficit by March 2008. Indisputably, eliminating the fiscal deficit is important, but this cannot be the only criterion for modifying depreciation rates and eliminating standard deduction and various exemptions for corporate and individual taxpayers.
One important aspect of the recommendations is reduction in the depreciation rate on plant and machinery, from 25 per cent to 15 per cent. The basic assumptions and statistical analysis of the task force are that plant and machinery will become obsolete in a 10-year period. It, however, does not take into account the fact that, today, obsolescence is much faster in most industries, especially in lead sectors such as automobiles; metals; telecommunications; infotech; oil-related industries such as prospecting and refining; power generation; and so on.
This key factor of reducing depreciation is not in accordance with the requirements of the modern, global world and compromises the Indian economy's capacity to save and invest in modern technology at the current global pace. In countries like the UK, capital costs are written off 100 per cent in the year of acquisition.
The second key feature of this report is the elimination of incentives, both to corporations and the individual taxpayer, partly compensated by more liberal tax rates and for individual taxpayers by following the EET (exempt during collection, exempt during accumulation and taxed during withdrawal) taxing method of savings (contributions to savings schemes to be taxed at the time of withdrawal).
But, over a period of time, inflation has reduced the real investible resources available with the corporate sector and the money available with individuals. The liberalisation of the tax rates was, in any case, necessary to adjust for inflation and the reduction in the rupee's buying power.
To say that the reduction in tax rates is enough to compensate for the increase in tax liability requires reconsideration. The new radical changes in tax saving schemes, especially for individuals, are much more complicated than the earlier ones and are against the stated principles of simplification, transparency and ease of administration that have been expounded in this report.
For corporations, incentives in key infrastructure areas, which require large capital investment, low returns and long gestation periods, should be continued so that the investible surpluses of the economy can be pushed to these sectors, rather than sectors that afford quick and easy returns to investors. I think these incentives help investors make up their mind to opt for these projects.
The lack of such incentives will put pressure on the government's scarce resources to invest in these sectors with the private investor shying away from them.
The third key feature of the recommendations is trying to bring corporate taxable incomes equivalent to the profit shown in the balance sheets under the Companies Act. This also needs to be looked at again. I do not know the methodology adopted wherein the effective rate of corporate tax in the manufacturing sector has been taken at 23.53 per cent and of the banking and finance sector at 28.11 per cent. One important sector that has been missed is services, which now contributes to a major share of GDP.
It would be interesting to know the effective corporate rate in the services sector as well. I suspect that the rates would be higher if tax is levied on profits before tax (PBT) reported in the audited profit and loss (P&L) account and balance sheets.
What, in fact, happens under the Income Tax Act is large-scale disallowances by adding back all mandatory provisions. For instance, under the mandatory accounting standards issued by the Institute of Chartered Accountants of India, which are also in line with generally accepted accounting principles (GAAP), provision of impairment of assets, provision for permanent reduction in the value of investments, provision for bad and doubtful debts, and creation of lease equalisation reserves require a debit to the P&L account, but are added back while computing the taxable income of a corporation.
If these add-backs are continued and the obsolescence (depreciation) rate is reduced, the effective rate of tax on most corporations following the mandatory accounting standards would be 5 to 10 per cent higher than the corporate tax rate prescribed by law.
Overall, that the task force has considered only one criterion for the country's economic health "" reducing the fiscal deficit. The negative impact on other economic criteria has been ignored and this may, ultimately, not yield the desired result of fiscal deficit elimination either.
