Exemptions raj

In his address to the Federation of Indian Chambers of Commerce and Industry a few weeks ago, the Prime Minister focused on the plethora of tax exemptions that riddle tax laws. Direct taxes have some large exemption loopholes, like the accelerated depreciation and backward industry exemptions. With nominal tax rates at 33 per cent, the fact that the average tax paid by companies is only around 20 per cent of profits, or less, suggests that there is certainly room for removing most of the exemptions and lowering the nominal tax rate.

The larger problem, though, is with indirect taxes, as suggested by the fact that the revenue from excise duties has been rising by only 6-7 per cent per annum, while industrial production has been rising by 10-11 per cent. According to the finance ministry's revenue-foregone statement issued last year, excise exemptions added up to over Rs 30,000 crore in 2004-05, or a whopping 30 per cent of the total excise collections for the year. Availing of each of several hundred exemptions requires that it be signed off by a competent authority who has the discretion to certify whether a unit is a small-scale one, or that the technology it is using is energy-saving, or that it employs fewer than 10 persons. This involves time, the possibility of corruption, and significant transaction cost. If a small-scale unit has to spend 15-20 days a year to satisfy the demands of the tax inspector, that is a huge cost in terms of both money and management time, and a drag on both performance and productivity.

In the case of customs, the tax foregone (without counting the exemptions related to exports) was estimated at Rs 57,000 crore for 2004-05, a figure slightly higher than the total collections for the year. It is surely a better idea to have lower tax rates on the statute than to get lower effective taxes through a plethora of exemptions that, as in the case of excise, are difficult and expensive to avail of. In the case of customs, there are 110 general exemptions, and each one of these in turn has a series of sub-exemptions. The biggest exemption, for instance, had 431 sub-exemptions under it last year, and has risen now to 458!

Apart from the revenue foregone, the loss of transparency and the opportunities for corruption, such exemptions also make it near impossible to streamline tax operations and transform them into an electronic, easy-to-administer system. Today, at a press of the button, finance ministry mandarins can find out whether international companies are paying a lower tax on profits than local companies. The same thing could be done across different units in the same industry, if the indirect tax system were to be made as simple as that for direct taxes. In other words, sorting out tax rates and exemptions is a natural corollary to improving tax administration, upgrading the quality of surveillance and plugging leakage.

Now that the Prime Minister, as well as finance minister, has focused on this issue, it must be hoped that action will follow words when the Budget is presented to Parliament at the end of the month. It would be tragic if the issue were to be framed and aired for more than a year, without action being taken to correct the situation.