Income distinction

Investment income should not be treated differently

The Union finance ministry is in the process of preparing the Budget for the next fiscal year, and it will be presented in less than two months from now. While the revenue position is fairly comfortable for the current year, the government intends to increase spending significantly compared to the budgeted amount. It has asked for Parliament’s approval to spend an additional Rs 3.74 trillion on different heads, though the actual outgo would be less because of savings under other heads. It is not entirely clear at this stage as to what extent it would push up the deficit and increase the government’s borrowing. The borrowing requirement will depend on how the revenue situation pans out in the remaining part of the year and to what extent the government is able to attain its disinvestment target.

Aside from fiscal calculations for the current and next fiscal years, it would also be important to see how the government moves forward on tax reforms to strengthen its finances over the medium term. In the context of goods and services tax, which cannot be altered by the Centre alone, a group of state ministers has been formed to look at rationalising rates to improve tax collection. The focus in the Union Budget will be on direct taxes and the government can take the reforms process forward by simplifying personal income tax. It should remove the distinction between how the income earned through labour and capital is taxed. Income from different types of investment is also treated differently and the distinction should be removed. All income can be taxed at the marginal rate.

This would not only simplify the tax structure but also remove distortions in the system, which affect individuals’ asset allocation. Investment should be made on the basis of an individual’s risk appetite, understanding of products, and asset allocation needs. Investment decisions should not be driven by how a particular instrument is taxed. In terms of taxation, it is often argued that equity investment must be taxed differently from debt because of the element of risk involved. But the risk aspect can be addressed by allowing individuals to offset losses as is the practice currently. It is also said that equity investment needs to be incentivised and higher taxes will discourage investors. The introduction of long-term capital gains tax, however, doesn’t seem to have affected the stock market. On the contrary, fund flows have pushed up valuations in the Indian stock market to a much higher level than in its peers.

Taxing investment income at the marginal rate would also help boost tax revenue. Wealthy citizens earn a large part of their income from assets and don’t need tax concessions. Further, the government also needs to review the exemptions. It has, in fact, given an option of lower rates without exemptions, but the need is to take the entire system towards that with more simplification. Again, it is the better-off sections of the population that benefit from exemptions. These changes, thus, will not only simplify the tax system but also boost revenue and make the structure more equitable. However, reforms are only one aspect of boosting tax revenue. The government must also focus on expanding the tax base and make sure everyone pays her or his fair share.