Nitin Desai: What the FM must do

Don't cook up projections to make the deficit look good, and don't hand out tax goodies to the middle class

P Chidambaram must be a worried man. A week from now he will present a Budget that is expected to revive growth, contain inflation and reduce the current account deficit. All this in a political environment in which party colleagues are demanding a pre-election tax bonanza for the middle classes and more welfare giveaways. Some of the balls that he has to juggle are bound to slip from his grasp, and the real test is what he allows to fall and what he chooses to protect.

A great deal of attention will be focused on the projected deficit. He will almost certainly crack down on the expenditure side. What one has to look for is where he holds down the increase — non-development expenditure, current development expenditure or capital spending. Given the objective of reviving growth, one hopes to see some boost to public investment, particularly in infrastructure where private investment projects are languishing.

The bigger issue is whether the revenue projection is cooked up to make the deficit figure look good. One element in this is the assumed growth in revenues, and anything much above 15 per cent for this would be implausible assuming six per cent GDP growth, six per cent inflation and tax buoyancy of 1.25. The other element in inflows is the proceeds of disinvestment. Mr Chidambaram set up the National Investment Fund, which was supposed to receive the proceeds from the sale of assets. One wonders whether he will revive this very sensible procedure or count the sale of public assets as a fungible resource under non-tax resources for meeting even current expenditures. (INCOME TAX LIMITS AND CPI)

Given the very tight macro situation, the finance minister’s room for manoeuvre on taxation is quite limited. There is the usual clamour for raising income tax exemption limits. Hopefully, he will resist this since there is no justification for it. In his 1997 Budget he set the basic three-rate structure, which continues to hold 15 years later. However, the exemption limit and the rate at which the peak rate applies are now much higher than the 1997 levels adjusted for inflation. Since 1997 the urban retail price index had gone up a little under three times. But the exemption limit has increased fivefold, and the income at which the peak rate applies has gone up more than sixfold. Till 2004 these two limits moved more or less in step with inflation; but since the United Progressive Alliance took over in 2004, a populist desire to please the middle classes has led to an increase in these limits well beyond levels justified by inflation (see graph).

The finance minister must resist the pressures from the salaried classes because there has been a bad erosion of the tax base in the lower tax brackets. The big problem of tax compliance is the failure to rope in millions of middle-income earners who stay out of the tax net altogether. Surjit Bhalla has demonstrated this convincingly in his calculations, which suggest that only 10 per cent of the assessees who ought to be in the lowest tax bracket actually pay tax. In fact his calculations suggest that compliance is better in the highest tax bracket. The increase in limits beyond what is justified by inflation adds to the problem by removing millions from the tax system.

There is some clamour for a tax on the super-rich, perhaps in the form of a surcharge on incomes beyond, say, Rs 1 crore. One can sympathise with this; it does seem a major violation of the principle of progressive taxation if someone who takes home Rs 10 crore pays nearly the same proportion of his income as tax as someone earning Rs 10 lakh.

There is an even more serious departure from tax progression: that is in the tax treatment of dividends. It has been argued that taxing dividends in the hands of the receiver amounts to double taxation since the corporation paying the dividend has already paid tax on its profits. But corporations are independent juridical entities that enjoy public services like national defence and law and order independently of individuals. The corporation tax is their payment for these services they enjoy as corporations. Taxing the profits they distribute does not amount to double taxation because the personal income tax is conceptually a payment for the public services that an individual uses.

We do tax dividends separately because we have a dividend distribution tax of about 16 per cent. But the tax is a uniform charge — and, implicitly, a pensioner with a few thousand rupees of dividend income pays the same proportion of this as tax as India’s richest individual and his family pay on the more than Rs 1,000 crore they receive as dividend income. This is a gross violation of the principle of tax progression. Collecting the dividend tax at source from corporations may have some advantages in reducing evasion. But some measure of progression can be introduced by requiring individuals to add dividends received to their taxable income and giving them credit for the tax collected at source in the form of the dividend distribution tax. The gains to the small dividend earner will be more than compensated by the much higher amounts paid by the billionaire owners.

There has also been some talk of an inheritance tax, as we are one of the few capitalist countries that do not have one. Though a good idea, it – along with other proposals for soaking the rich – will run contrary to the need to maintain a buoyant stock market to continue attracting money from foreign institutional investors. FII inflows are sorely needed to cover the current account deficit and to facilitate disinvestment of public shareholding, which is crucial to fiscal deficit management.

On the balance of payments front, little can be done except for continuing with various export incentives and cracking down on gold imports. Nearly 40 per cent of the new gold demand in the country is for investment purposes. This demand is sensitive to prices and expectations about future gold prices and prices of competing assets such as stocks and property. This is another reason for aiming at maintaining stock market buoyancy.

The Budget will include pious promises about reforms. Perhaps the most important promise is about the time frame for the introduction of the goods and services tax. The greatest challenge, however, is that the finance minister has to lift the cloud of gloom that hangs over the economy.

nitin-desai@hotmail.com