'Exemption raj'

Most people have suspected for long that the exemptions given in the tax rules, for a variety of reasons (some of them quite creative), have ended up giving very special treatment to the favoured categories, at everyone else's expense. However, no one had a precise estimate of the extent of damage done by this 'exemption raj'. The finance ministry's numbers, revealed for the first time in the Budget papers, are stunning at Rs 158,661 crore in 2004-05. This is more than half the gross tax collections for that year. In other words, tax rates could be dropped by half, across the board, if the exemptions are done away with--and the country would get (in the finance minister's words) "horizontal equity" as a result. This is a finding of the highest importance, and underlines the importance of getting rid of exemptions as much and as quickly as possible. Even if some exemptions are politically impossible to tackle, it should be possible to do away with the rest and win acceptance for this by dropping tax rates by an equivalent amount so that the exercise is revenue-neutral.

The issue is the defective design of India's taxation system. It has been evident for some time that the ratio of excise to industrial GDP has been falling. While the exemptions are Rs 30,000 crore in the case of excise, it is twice that when it comes to customs duty exemptions--the Rs 35,000 crore or so of export-linked refunds/rebates don't count since they deal with refunding excess levies. Apart from the fact that Rs 90,000 crore worth of exemptions must spawn a lot of corruption, is the country getting a huge boost in either investments or jobs by giving away what amounts to 2.8 per cent of GDP by way of tax revenue? The decision to invite comments on each one of these notifications so that they can be removed is a step forward, though the fact that large tax benefits have just been offered to special economic zones makes the possibility of corrective action seem remote.

Meanwhile, the Kelkar report (which had pointed to the excise problem) also showed that companies were paying taxes that were much below their nominal levels. Indeed, the tax-expenditure exercise, introduced for the first time in this Budget, seeks to replicate and extend what the Kelkar report did. Data were taken from various tax centres across the country and the taxable income declared by each company was plotted against the financial information reported by the same companies, as available from the CMIE database. This showed that, compared to the statutory tax rate of 35.875 per cent, the effective tax for the sample companies was a mere 19.37 per cent. Even more shocking, it was found that companies that declared profits-before-tax of over Rs 500 crore were paying effective tax rates that were even lower, a tad under 16 per cent. Since the number of such companies isn't large, it should be easy to address the issue. The problem is perhaps not with the companies as with the tax rules that permit companies to avoid paying tax (as different from tax evasion). It is this which has to be addressed. Now that Mr Chidambaram has highlighted the problem in the Budget papers, it must be hoped that action will follow.