Why economy needs combination of tax incentives, low tax rates

The effective rate of corporate taxation in the country is 23.2 per cent for companies with an income of Rs 10 crore ($1.6 million) or more, which is lower than the statutory rate by a full 10 percentage points. This is due to incentives to promote investments or to direct investments towards targeted activities.

But smaller companies have not been able to fully avail of the incentives. A study of 56,4787 companies by the Department of Economic Affairs for the year 2013-14 estimated that companies having an income of less than Rs 10 crore ($1.5 million), excluding loss making companies, pay an effective corporate tax rate of 26.3 per cent. These companies constitute more than 50 per cent of firms in the study but earn less than 10 per cent of the total income before tax.

Large companies with income of over Rs 500 crore ($79.7 million), numbering only 263, account for 60.3 per cent of pre-tax income for all the companies and pay an effective tax of 20.68 per cent against the statutory rate of 33.99 per cent.

Other medium-sized companies numbering 6,325 had a 29 per cent share in income before tax and a 31 per cent share in taxes. The effective tax rate was 24 per cent.

Also, the benefit of incentives accrues more to the public sector than their private counterparts. The 221 PSUs in the study earned 24 per cent of the total pre-tax income, but paid only 20 per cent of total taxes. As a result, the effective rate of taxation for PSUs was 19 per cent against 24 per cent for private players.

The projected revenue loss due to incentives in 2014-15 is estimated was Rs 62,400 crore ($9.94 billion). Accelerated depreciation and exemption on export profits from SEZs and power companies account for two-thirds of total incentives.

Accelerated depreciation alone account for one-third of revenue loss. But that is not really the right way to estimate revenue loss since total depreciation has to be paid in any case. With acceleration, the tax payable is only postponed and consequently, only the interest borne by government on the incentive should be considered as genuine loss.

When it comes to power, the sector was slow to attract investment because of excessive regulation, so removing incentives should not be considered. What about SEZs? Exports are critical and in an intensely competitive market, every country compensates exporters one way or the other. And benefits for companies in SEZs are anyway minimized by MAT against original tax exemption of export profits.

It would not be prudent to withdraw the incentives unless corporate tax is brought down substantially. A combination of tax incentives and a reasonable tax rate is best for a transitional economy like India.

(The author undertakes research on current macroeconomic issues of interest, mainly to industry, as president of RPG Foundation, a private think tank. Any opinions expressed here are those of the author) - Reuters