Let’s not forget direct tax reform

The nationwide rollout of the new Goods and Services Tax (GST) is a historic occasion, however imperfect its beginning. It is the biggest reform in indirect taxes. It arose as a grand bargain reached by consensus between twenty-nine States of India and the Centre. It represents the true spirit of cooperative federalism, a term popularised by Prime Minister Narendra Modi. Each party to the grand bargain gave up their respective taxation rights in exchange for a uniform countrywide system. The States gave up sales tax (also called VAT) and the Centre gave up excise and service tax. Most importantly, the central sales tax imposed on inter-state commerce is abolished, and so are most other entry taxes at State boundaries. This creates a truly un-fragmented and unified common economic market across India. This is the vision and ideal that we aim for.

The imperfection is that we have left out nearly one third of the economy and GDP outside the ambit of GST. Thus taxes and duties paid on electricity, petrol, diesel, alcohol, tobacco and real estate transactions, do not earn any offsetting credit under GST. Hence, to that extent, the GST burden is on a smaller portion of the economy, and therefore likely to be inflationary in the beginning. The second imperfection is that instead of just one or two rates for all goods and services, we have introduced six rates of 0, 5, 12, 18, 28 and 43 percent. The so-called luxury goods attract higher rates, and essential goods a lower rate. But this classification is so complicated and at times inconsistent, and subject to the discretion of tax officials, that it might lead to disputes, litigation and worse, corruption.  The third imperfection, hopefully temporary, is that India’s GST, unlike in any other country, is actually three simultaneous tax systems, viz, CGST, IGST and SGST. The compliance and filing burden can be onerous, although they have promised smooth execution of the online mechanism.  But despite all the drawbacks, we must celebrate this landmark reform.

At the same time, we also must acknowledge that it is only half the job done, as far as tax reform is concerned. The two reports of committees chaired by Dr. Vijay Kelkar back in 2002 were on indirect taxes and direct taxes. GST is an indirect tax. It is a consumption and transaction-based tax. The full impact of tax reform and attendant benefits are only possible when we implement both direct and indirect tax reform. The principle of optimal taxes requires efficiency and equity. The former means tax reform which causes least distortion, easy to comply and collect and leads to revenue buoyancy.  Hopefully, the ideal and full version of GST meets these criteria. But the latter, i.e. the equity notion, requires that taxes also be “fair”.

There are two notions of fairness – horizontal and vertical equity.  The former means,  that two persons earning the same income should pay a similar tax amount. The latter means that a higher income earner should pay more taxes than a lower income earner, both in absolute terms and as a percentage of income.  Indirect taxes such as GST are inherently unfair because they only depend on the value of the transaction, not on the buyer’s income. Direct taxes like income tax, capital gains tax and wealth tax are fairer and can be progressive. In a fair and just society, we need higher income persons to contribute more to the national exchequer than those less fortunate.  Taxes should be seen as each person’s membership fee to be able to live in a civilized and democratic society. Justice Oliver Wendell Holmes famously said in 1927, “I like to pay taxes. With them, I buy civilization”.

In that sense, taxes are not an unjust imposition of a tyrannical state but a conscious, voluntary contribution of each citizen. For this to happen, the share of direct taxes in the total taxes collected should be as high as possible, may be more than two-thirds. Besides, the direct tax system should have low and reasonable tax rates, simplicity of code and minimal exemptions. Indeed, these are the principles adopted by the Kelkar Committee on direct tax reform.

In India, the ratio of indirect to direct taxes collected in the aggregate, is 65 to 35. That ratio should be reversed. The GST reform may actually make the ratio more adverse. Hence, unless we also undertake direct tax reform, our task is unfinished. It is true that nobody likes to pay taxes, treating them almost like a necessary evil. But if one looks at them in the spirit of Justice Holmes, and if the reforms go by the principles laid down in the Kelkar Committee report, then we have a chance of a fair and efficient tax system. This would mean that any income, be it from whatever source, should be taxed. This is so long as it is above a particular threshold, say Rupees five lakh per annum per person.

The plethora of exemptions given to corporate taxes should go away, and be replaced by a lower rate instead. The Finance Minister has already assured a route to 25 per cent corporate income tax. Dividend income above a threshold of, say, Rs. 10 lakhs should attract some taxation. Capital gains tax policy should be made uniform for all asset classes, be they stocks, bonds, derivatives, real estate, art or gold. Zero capital gains should accrue only if the holding period is at least three years. The current policy on long-term capital gains exemption is far too generous. These are all sensitive issues and need a debate and rapid consensus to be evolved. What is undeniable is that we must embark on reforming direct taxes, simplifying the code, widening the tax net and making the tax ratio of indirect versus direct, less skewed and fairer. Celebrate the launch of GST, pop the champagne, but get on with direct tax reform pronto.

(The author is a senior economist based in Mumbai and Senior Fellow, Takshashila Institution)