Business Today

Fewer exemptions, greater gains

The Direct Tax Code wants us to give up all tax exemptions in exchange for lower tax rates and easier compliance. The government gets a larger income tax base and the taxpayer a lower rate.

Babar Zaidi and Puja mehra         Print Edition: March 21, 2010

We all think that the tax burden is equal to the tax rate - higher the rate, higher is the tax we pay. This simple equation tells only half the truth. The tax burden also depends on a whole host of tax exemptions and reductions that we claim - on HRA, medical allowance, conveyance, LTA, etc. Then, there are many incomes that are tax free, such as the interest earned on PF and PPF. Capital gains are either tax free or taxed at a lower rate. Taking these exemptions into account, a person in the 30 per cent income tax bracket may actually pay an effective tax of only 15 per cent or even lower. Wouldn't it be simpler if taxpayers stop claiming all these exemptions and the government reduces the tax rate in proportion to the value of these exemptions? Yes, and that is exactly what the Direct Tax Code (DTC) promises to do.

End to Misallocation
Exemptions not only lower the effective tax burden, but also impact the savings and consumption patterns of people. By doing away with the maze of exemptions, the DTC would ensure that the decision to invest and consume is not guided by tax considerations. For instance, the tax deduction offered to life insurance makes people buy policies not to cover the risk of death but to save tax. Since the customer wants higher tax savings, he opts for a policy with a high premium outgo and usually ends up buying an unsuitable plan. The DTC addresses this problem by removing the tax exemption to income from insurance policies where the premium is more than five per cent of the insured amount.

The code also proposes to end certain anomalies in the current tax regime. There is no rationale for taxing returns from different asset classes-be it gold, equity shares or a house-differently. Income is income whether earned from fixed deposits or capital gains on an asset, salary or any other source. Another basic principle of taxation is that all taxes should be borne by persons and not organisations. This means entities such as mutual funds shouldn't pay taxes but people who invest in and earn from them should.

But the dividend distribution tax (DDT) on non-equity funds is an indiscriminate tax that is levied on all investors irrespective of their income level. A better way is to remove the DDT payable by companies and mutual funds on the dividend payout and instead tax the dividend in the hands of the investor as proposed by the DTC.

Similarly, partnership firms shouldn't pay taxes but the partners should. Though this principle would require shareholders rather than companies to pay taxes, the DTC makes an exception for them. This is because normally a small chunk of shareholders own a disproportionately large shareholding in the corporate sector. If promoters own 70 per cent of a company that makes a profit of Rs 1,000 crore, their tax liability would be nearly Rs 210 crore on an income of Rs 700 crore.

DTC DECODED: GAINS ALL AROUND

  • 97 per cent of existing taxpayers will pay 10 per cent income tax after the direct tax code is implemented. Right now 65-70 per cent taxpayers are in this slab.
  • 13,643 rupees a year is the average exemption from income tax per taxpayer. Total revenue forgone in income tax exemptions is Rs 40,929 crore.
  • 36 croreis the estimated man hours lost in working out ways to avail of tax exemptions in a year.
The Culture of Evasion
Thanks to the exemptions and deductions offered by tax laws, we have willy-nilly turned into a society of tax evaders. This could change under the DTC because if all perks and allowances will be taxed as income, there won't be any need to produce fake rent receipts or bogus medical blls. This will not push up an individual's tax outgo because the higher slabs will provide relief. Right now, 65-70 per cent of taxpayers pay tax at the rate of 10 per cent. Under the DTC, about 97 per cent people will pay 10 per cent. What's more, the raising of slabs could also be an incentive for taxpayers to report higher incomes.

Even the change in tax on capital gains will not add to the tax burden. The removal of exemption on long-term capital gains from equities may appear like a setback. But the rate of corporate tax is also proposed to be reduced from the present 34 per cent to 25 per cent. This will boost the bottom line of companies and lead to higher valuations-and therefore, higher gains for investors. Besides, the DTC allows for long-term capital losses from equities to be set off against gains. These losses can be carried forward indefinitely. Also, the DTC provides for a Capital Gains Deposit Scheme which allows rolling over the gains so that they are taxed only on withdrawal.

Savings for Retirement
The change from the exempt-exemptexempt (EEE) model of taxation to the exempt-exempt-tax (EET) regime has been widely criticised. Taxing retiral benefits at the time of withdrawal is seen as a cruel blow for retirees. However, contrary to the perception, the EEE principle is not conducive for retirement. It doesn't encourage savings but facilitates churning and recycling of the same savings. An individual who invests Rs 1 lakh every year in NSS certificates will from the eighth year onwards start getting Rs 2 lakh as the investment matures. Thereafter, he may simply reinvest the maturity proceeds. In effect, he may "save" only for 7 years and then recycle his money without actually adding to his savings.

On the other hand, if there is a tax on withdrawals, the individual will remain invested for the long term and withdraw only to the extent necessary for basic consumption. This will encourage long-term retirement savings, which are so crucial for a nation that faces the threat of old-age poverty in the next 30-35 years when today's youth will be nearing retirement. These people should be encouraged to save more and for the long term.

The Blind Spots
However, some blind spots remain in the DTC. Since it was first released in August 2009, the draft Code was criticised on some points and has gone back for redrafting and a possible April 2011 implementation. For one, the difference in the treatment to salaried taxpayers and self-employed professionals will become more pronounced.

The exemptions and deductions enjoyed by the salaried class have been taken away, but self-employed professionals will continue to avail of tax deductions. A salaried person with a gross annual income of Rs 12 lakh and savings of Rs 3 lakh will pay Rs 74,000 as tax without any deduction. A consultant who earns as much will be able to reduce his tax to about Rs 24,000 by claiming deductions amounting to Rs 5 lakh. The DTC ought to ensure that there's no discrimination between different types of taxpayers. Then it would truly achieve its objective of ensuring equity in taxation.


INCOME TAX: NOW and THEN
 CURRENT PROVISIONSBUDGET 2010 PROPOSALSLIKELY FROM APRIL 2011
Tax SlabsUp to Rs 1.6 lakh annual income. No tax.Up to Rs 1.6 lakh: No tax.Up to Rs 1.6 lakh:
No tax.
Rs 1.6 lakh to Rs 3 lakh: 10%Rs 1.6 lakh to Rs 5 lakh: 10%Rs 1.6 lakh to Rs 10 lakh: 10%
Rs 3 lakh to Rs 5 lakh: 20%Rs 5 lakh to Rs 8 lakh: 20%Rs 10 lakh to Rs 25 lakh: 20%
Above Rs 5 lakh: 30%Above Rs 8 lakh: 30%Above Rs 25 lakh: 30%
AllowancesExemption to HRA, medical, conveyance, LTA, telephone allowances, subject to conditions.No change.All allowances to be added to income and taxed at marginal rate.
Dividends from companies and mutual fundsDividend tax free, but dividend distribution tax on dividends from companies and non-equity funds.No change.Dividend income added to income and taxed. Dividend distribution tax to be abolished.
Securities transaction tax0.125% of the value of the transaction.No change.STT abolished.
Capital gains from equities and equity-oriented mutual fundsShort-term gains taxed at 15%, long-term gains tax free.No change.All gains to be added to income and taxed at marginal rate.
Capital gains from other assetsShort-term gains added to income, long-term taxed at 10% or 20% with indexation.No change.All gains to be added to income and taxed at marginal rate. Indexation benefit to continue.
Capital losses from equitiesShort-term losses can be set off but no provision to set off long-term losses.No change.Long-term losses can be set off and rolled over indefinitely.
Tax saving limitRs 1 lakh under Sec. 80 C.Rs 1.20 lakh. Additional Rs 20,000 for infrastructureRs 3 lakh under Sec. 66.
PF, PPF and other exempted savingFully exempted at all stages-investment, growth and withdrawal.No change.To be taxed at the time of withdrawal.
Insurance policiesIncome is fully exempt. It is taxable only if the
cover is less than 5 times the annual premium.
No change.Income to be taxed if the cover is less than
20 times the annual premium.
Home loan interest deductionUp to Rs 1.5 lakh of interest paid eligible for deduction for selfoccupied houses. No limit if house is given on rent.No change.No deduction for self-occupied houses.
Available if house is given on rent.
Wealth Tax1% tax payable if market value of jewellery, vacant house, car, artefacts, and cash exceeds Rs 30 lakh. Financial assets exempt.No change.All assets to be included, but at cost price not market value. Rate reduced to 0.25% and threshold raised to Rs 50 crore.

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