GS-III: It’s time for a direct tax regime that’s growth-focused and fair.

CONTEXT

India overhauled its indirect tax system with the introduction of goods and services tax (GST). It now has to do the same with the direct tax system.

Background

The task force on the direct tax code (DTC) submitted its final report to the finance minister. The proposed new code will replace the Income-tax Act of 1961.

DTC – what it has to say about direct taxes

• The report says that the direct tax system is designed to improve the efficiency, equity, and effectiveness of the tax system.
• A good tax system has to promote rather than hinder economic activity, aid economic equality rather than inequality, and be easy rather than complicated to administer.
• The task force argued that high tax cost on return on equity inhibits private sector investment.
• They suggested that a sharp reduction in the corporate tax rate can substantially reduce the tax cost on equity. This will also eliminate the bias in favour of debt.
• This will enable the revival of private sector investment and reduce bankruptcy risk.
• A lower tax on capital could increase inequality. The task force has sought to counter it with the reintroduction of a wealth tax.
• It recommended that policymakers have to think of the tax system as a whole, rather than obsessively focus on each part separately.

Debating the proposals

• International experience shows that zero tax on capital is impractical. But lower corporate taxes could bring down the general cost of capital in India.
• Global tax reforms over the past few decades have flattened marginal tax rate schedules. There is now a narrower gap between the lowest and top marginal tax rates.
• Some ideas on optimal tax theory suggest that tax rates should generally be higher in societies with greater income inequality.

GST lessons

• The GST design was based on sound economic principles derived from the theory of optimal taxation.
• The tax is imposed on final consumption goods rather than intermediate goods.
• It sought to impose a uniform tax rate on most consumption goods. But this was compromised during the complex federal bargain
• The idea that each tax has to be progressive has led to a complicated GST that is now resulting in suboptimal revenue.

Direct – Indirect tax shares

• In the distribution of revenues from income versus consumption taxes, the former tends to be progressive, while the latter tends to be regressive.
• Before the 1991 reforms, India had a regressive tax system because of the overwhelming dependence on indirect taxes. Direct taxes then contributed less than one-fifth of total tax revenue.
• Now, the two types of taxes have approximately equal weights in government revenues.

Way ahead

Direct taxes have to keep growing in importance as labour and capital incomes rise. A new DTC will be important in a distributional sense. Higher direct tax collections can create space for a restructuring of the GST.