Can India end the exemption raj in personal income tax system as well?

The trajectory of how India’s corporation tax rates have moved since the economic reforms of 1991 shows quite clearly that their reduction to 22 per cent, through an ordinance last Friday, has been a slow and steady process. It has taken almost 28 years before the corporation tax rates (without surcharge or cess) could be brought down from 45 per cent in 1991 to 22 per cent in 2019. This is a 51 per cent drop in the tax rates for companies. 

But compare it with the pace of reduction in personal income-tax rates, a slightly different picture will emerge. The peak rate of personal income-tax rate (without surcharge and cess) dropped from 50 per cent in 1991 to 30 per cent in 1997. This was a 40 per cent drop in just six years. The peak rate has not changed since then and remains at that level, even as surcharges and cesses have been levied in this period, raising the overall incidence of income-tax on individuals in the top income bracket.  

Two trends are noticeable. One, although corporation tax rates have seen a steeper cut, the reduction has taken place over a longer time frame. Personal income-tax rates were slashed quickly, but after that they stayed at the same level for a long period. Two, the incidence of surcharge and cess on personal income-tax is a little more than on corporation tax rates. The peak personal income-tax incidence, as a result of surcharge and cess is now 42.7 per cent — over 12 percentage points higher than the tax rate. But the incidence of corporation tax, after including the impact of surcharge and cess, has taken the rate of 22 per cent to 25 per cent only. 

Returning to the trajectory of India’s corporation tax rates since 1991, it is important to note that its journey did not begin well in the early years of economic reforms. In his first Budget, which he presented in July 1991, Manmohan Singh actually raised the corporation tax rate from 40 per cent to 45 per cent. And the reason Dr Singh cited in support of his decision was poor tax collections. 

Six years later, Palaniappan Chidambaram, finance minister in the United Front government, struck a different note in his Budget for 1997-98. He recalled how in the previous year, he had already halved the surcharge on corporation tax to 7.5 per cent and now he was abolishing it completely. It seemed then that Mr Chidambaram had no love for surcharges, which are not shared with the states. His logic for reducing the corporation tax rate to 35 per cent was that lower rates would encourage companies to become more compliant and undertake new investments.

Less than a decade later, Mr Chidambaram was back again in the saddle in North Block, headquarters of the finance ministry. As finance minister under Manmohan Singh, who was now the prime minister, Mr Chidambaram cut the corporation tax rate by another five percentage points to 30 per cent to give the corporate sector a measure of relief. That was in his Budget for 2005-06.

But note that the surcharge was back. He announced: “There will also be a surcharge of 10 per cent.” As finance minister under the United Front government, he slashed the corporation tax rate by 10 percentage points and abolished the surcharge, but under the Congress-led United Progressive Alliance government, he reintroduced the surcharge at 10 per cent. Governments’ fascination with surcharges over the years has shown no sign of ebbing, as the Centre is becoming greedier to corner a larger share of the taxes it collects.

In 2015-16, the debate on corporation tax rates took a different direction. As finance minister in the Narendra Modi-led government, Arun Jaitley raised the issue of exemptions and incentives that had distorted the taxation system. He also admitted that the basic corporation tax rate at 30 per cent was higher than those prevailing in other major Asian countries, making the Indian industry uncompetitive. But he also noted that because of the many exemptions the effective collection of corporation tax was only about 23 per cent. Jaitley said: “We lose out on both counts, i.e. we are considered as having a high corporation tax regime, but we do not get that tax due to excessive exemptions. A regime of exemptions has led to pressure groups, litigation and loss of revenue. It also gives room for avoidable discretion.”

Jaitley thus announced his plan to reduce the corporation tax rate from 30 per cent to 25 per cent over the next four years, so that increased investment leads to higher growth and more jobs. More significantly, he announced a time-table for phasing out the various exemptions, so that tax payers got advance notice of their discontinuation. A year later, he indeed outlined a plan for phasing out various exemptions and gave new manufacturing companies the option to be taxed at 25 per cent plus surcharge and cess, provided they did not claim profit-linked or investment-linked deductions. 

In addition, he brought down the tax rate for companies with a turnover of up to Rs 5 crore to 29 per cent plus surcharge and cess. In 2017-18, Jaitley went a step further by announcing a corporation tax rate of 25 per cent for all companies with a turnover below Rs 50 crore. A year later, the threshold for enjoying the lower taxation of 25 per cent plus surcharge and cess was enhanced to a turnover of up to Rs 250 crore and Nirmala Sitharaman, in her first Budget as finance minister, raised it further to Rs 400 crore. This meant almost 99.3 per cent of all companies were covered by a lower taxation of 25 per cent. 

What Ms Sitharaman announced last Friday was actually an extension of Jaitley’s principle of an exemption-free taxation regime for companies. Of course, the tax rates were also brought down, to make them closer to those prevailing in other Asian countries. But a more significant change was a signal to end the exemption raj in the corporation tax regime. The lower tax rate was like an incentive for the companies to give up exemptions. Those who would opt for the lower rate would not be able to go back to the earlier regime of slightly higher taxes with exemptions. 

In the process, the corporation tax system would also become more transparent, with reduced scope for litigation and discretion. If the decision of last Friday can woo the entire corporate sector away from those exemptions and guide it to opt for the lower tax regime, the government would succeed in ushering in a big reform in India’s tax system, apart from reducing its outgo on financing the exemptions. The question is whether Ms Sitharaman would be able to extend the same principle of lowering rates while doing away with exemptions to the personal income-tax system as well.