The Double Taxation Problem
An assessee who runs a business is taxed on the net income arising therefrom. If the business is in a company, that income is taxed twice; first since the whole of the net income is chargeable to profits under corporation tax and a second time, when the remaining income is distributed to shareholders and added to their personal income.
The arithmetic of this is straight-forward. Let us assume, inaccurately but for the sake of simplicity, that income and corporation tax are levied at the rate of 40 per cent and 45 per cent, respectively. In that event, owning the business directly will attract a tax of 40 for every 100 units of income. If, on the other hand, the asset is owned through a company, it will attract 45 units by way of corporation tax and whatever is distributed from the balance 55 units of income will attract further tax at 40 per cent. Thus, for example, if the entire 55 is distributed there will be a further tax of 22 units (55 *0.40) making a total of 67 units of tax as against 40 units of tax when the business is not in a company.
Prima facie there is no reason for taxing an economic unit at a higher rate simply because it is owned indirectly. It is the interaction of corporation tax and income tax that leads to the problem. The standard view in economic textbook literature is that corporation tax represents double taxation of the return to capital in the corporate sector. (Stiglitz Economics of the Public Sector). The finance minister has tried to mitigate against the mischief of this double taxation by reducing the tax on distributed income. This is somewhat perverse as the problem arises out of the imposition of corporate tax and the remedy should, therefore, have been the abolition of corporate tax itself. But there may have been complications about doing this under the various international tax treaties.
Instead, the finance minister has compensated those who would have been taxed twice by exempting dividends from income tax and, simultaneously, he has tried to make up government revenues by introducing a dividend tax on distributed profits. This tax has been imposed on companies. This unhappy mix of compromises has roused the ire of the erstwhile chairman of the tax reforms committee Raja Chelliah.
In Business Standard (April 26), Dr Chelliah attacked the new proposals on two main grounds. First, he objected to the shift in burden of tax from individuals to companies. He told us that tax should be levied on individuals, according to their relative abilities to pay; taxing a conduit instead of the recipients of income is an inferior alternative. But on this point he is not entirely consistent; indeed he seems to have hoisted himself on his own petard. If it is wrong to tax conduits then the whole rationale for taxing companies disappears. Companies, after all, are nothing but conduits gathering income for their various owners. Indeed, the strongest argument against levying a corporate tax is that companies earn nothing for their own benefit but only for their many proprietors and shareholders.
In principle, therefore, a company should not be taxed. It is a pity that Dr Chelliah did not show Manmohan Singh how to achieve that. Perhaps the tax has been imposed on companies only for administrative convenience. But if that is the case, companies should be deemed to be paying tax on behalf of their shareholders. This indeed was the old system. Both the income and the tax were imputed to the ultimate beneficiary the owner of the equity. This was the way the income used to be treated in Britain, from whom we borrowed these concepts. That was until Morarji Desai decided otherwise. He developed the notion, prevalent in legalistic America, that a company was a separate juridical person from its owners and should, therefore, be taxed as a distinct unconnected entity.
As a piece of judicial logic, this reasoning was sound. But in economics as in matrimonial issues what has been put together in heaven or by nature let no man put asunder. An individuals attachment to his wealth is difficult to separate, and any tax on companies to which he claims partial ownership reduces the return on the capital he has invested. The incidence of corporation tax falls ultimately on the class of shareholders.
No one knows the consequences of this burden on investment and economic growth; but it is reasonable to surmise that investment in stocks and shares will prove less attractive than it otherwise would have been, and will thus have been discriminated against in comparison with other investments like real estate, where the pattern of ownership is direct rather than corporate.
Thus the interaction of corporation and personal tax will have acted as a brake on economic growth. The authorities had tried to counter the negative impact of corporation tax by offering all sorts of concessions under Section 80 of the Income Tax Act. But along came Hopalong Cassidy in the form off Dr Chelliah who promised to clean up the system and remove anomalies so that concessions would become redundant. Unfortunately, he did not tackle the problem thoroughly. A new finance minister decided to go further in rectifying aberrations thereby provoking the wrath of the early reformers.
In the second part of his attack, Dr Chelliah tried to lead us into a classic trap by using an old lawyers trick. He asked a question equivalent to Have you stopped beating your wife? which cannot be answered with a simple yes or no, for if you say yes it implies that you have been beating her in the past and if you say no it suggests that you are continuing to beat her now. Dr Chelliahs equivalent implied question is: Do you believe in the principle that equal incomes should be taxed equally regardless of their source ? If you say yes you appear not to approve of exempting dividends from tax, but if you say no you are automatically labelled as an antiquated right wing knave. The ruse in what logicians call the fallacy of many questions is to conceal the real issue by asking a question that is only partially relevant.
The real issue that Dr Chelliah refuses to address is: Should we tax corporate income twice over? There may be no unequivocal answer but that does not mean we should not ask the question. Rationally, the finance minister might have done better to scrap corporation tax altogether and left the tax on personal income unchanged; but the merits of these arguments must be left for another time. Suffice it to say that Mr Chidambaram is trying an interesting experiment and its success can only be judged from the response of economic agents.