The Telegraph
Since 1st March, 1999
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The recently submitted Kelkar committee reports on direct and indirect tax reforms have attracted a great deal of attention, as if these are to be implemented in the near future. This prompted the finance minister to declare that these are only working papers and the entire set of recommendations may not be implemented. Nonetheless, all kinds of people including economists, tax experts, businessmen and ordinary tax payers, have taken the reports very seriously since Vijay Kelkar happens to be the economic advisor to the government of India.

Due to space constraints, this article will concentrate on a few of the major direct tax proposals, leaving aside the indirect tax part. The report proposes to abolish virtually all kinds of deductions for computing taxable income such as standard deduction, deduction against housing loan, life and medical insurance, savings in various schemes like the national savings certificate and tax saving bonds. To offset the implied higher tax burden, the report recommends that the basic exemption limit be raised from the current Rs 50,000 to Rs 1 lakh. Further, the current three income tax rates (10 per cent, 20 per cent and 30 per cent) would be replaced by a two-tier system. A 20 per cent rate will apply to income between Rs 1 lakh to Rs 4 lakh per year and the highest 30 per cent will apply to all income above Rs 4 lakh.

No doubt, the plethora of exemptions and deductions makes the tax system complicated. Moreover, it may be inequitable. For example, suppose Mr Xs wife earns some money by private tuition or from inheritance. But she is not a taxpayer since her total income is below the exemption limit. Mr X can reduce his tax burden by partly meeting his household expenditure from his wifes income and investing his own savings in NSC. Mr Y has exactly the same income and expenditure as Mr X, but Mr Ys wife has no income. In that case, Mr Y will have less savings and hence a higher tax burden. Mr Y is doubly cursed his total family income is less but he ends up paying more taxes. Clearly, the system favours people already better placed in life.

One oft-mentioned argument for retaining deductions is that these promote savings. But empirical evidence suggests that these mainly affect the composition rather than the total volume of savings. If one gets a tax saving by investing in NSC but no such saving from bank fixed deposits, one would put less money in banks and more in NSC.

Tax saving instruments like the Reserve Bank of India bonds carry a tax-free interest of 8 per cent. With a 30 per cent marginal income tax rate, this is equivalent to more than 11 per cent interest on bonds or fixed deposits whose interest is not tax-free.

This would mean that people would put more money in the tax-saving bonds unless the interest on bank fixed deposits is comparably high. Thus, the tax-saving bonds are putting an upward pressure on the overall interest rate structure when the government is trying to bring down interest rates. The cost to the government of raising funds through RBI tax-saving bonds is actually more as the government has to take into account the implied tax revenue loss. This is yet another argument for abolishing the tax savings allowed on investment in some designated schemes.

Though most economists agree on the wisdom of abolishing the deductions, they do not agree on the advisability of doubling the exemption limit at one go. The apprehension is that a vast mass of lower end income tax assesses (about 40 per cent of taxpayers) would go out of the tax net. Some of them would have graduated to higher tax brackets later. They also point out that Indias exemption limit is not particularly low by international standards. So, according to this view, the exemption limit should not be raised and the entry level 10 per cent low tax rate should be retained. The widening of the tax brackets, particularly applying the 30 per cent rate to only those earning Rs 4 lakh and above, would bring tax relief to all taxpayers, compensating for the loss of deductions.

The second possible problem is that the policymakers may accept only the populist part of the recommendations, namely raising the exemption limit and widening the tax brackets, but would not allow the deductions to be abolished on the ground that they would be anti-savings and so on. This would mean a significant reduction in direct tax revenues.

The third objection is that the reforms would affect the lower middle income class particularly hard, as compared to the current situation. For instance, calculations indicate that a person earning Rs 1.2 lakh annual salary would end up paying Rs 3,120 as taxes under the Kelkar scheme, whereas he is paying no taxes at present if he can save Rs 35,000 in specified savings avenues.

By contrast, a person earning a salary of Rs 3.5 lakh can have a tax burden lower by Rs 8,000 under the Kelkar scheme as compared to the existing situation. This would happen, despite the denial of deductions, because of the lowering of the effective average tax rate through widening of tax brackets. A high income salary earner of Rs 7 lakh per annum would be able a save about Rs 35,000 in taxes under the proposed scheme as compared to the present. This large tax-saving is due to the fact that people earning more than Rs 5 lakh are not getting the benefits of standard deduction and section 88 deductions on savings even now. For them, the widening of tax brackets would be the only relevant thing. Thus, the Kelkar proposals would give a better deal to the higher income earners and may therefore be considered less progressive. This feature may be used by the critics to shoot down the proposals as pro-rich.

It is also not clear how far total tax revenue would be affected by the proposals, though the Kelkar report emphasizes that the overall impact would be revenue-neutral. Unfortunately, detailed numerical calculations are not presented to support this contention. Further, some critics argue that it is not enough to keep the share of tax revenue from income tax unchanged. Initiatives need to be taken to raise the share of direct taxes and reduce the share of indirect taxes over time. The Kelkar proposals do not contribute to this goal.

The other significant and far-reaching proposal is to introduce an agricultural income tax. This is often talked about but never done. Since it falls under the domain of state governments who generally do not like to go for this unpopular move, the suggestion is to amend the Constitution and give the Central government the power to levy the tax, which would in turn distribute the proceeds to the respective state governments. But what makes one think that the Central government, in particular, the current coalition government would consider it prudent to introduce this tax and alienate the large rural vote bank'

Jagdish Shettigar, the chief of the economics think tank of the Bharatiya Janata Party, has reportedly said that the implementation of the Kelkar proposals, in particular the abolition of deductions and the introduction of agricultural income tax, would bring electoral disaster for the party in both urban and rural areas.

So, chances are high that the Kelkar report on direct taxes would be another report gathering dust. At worst, parts of the proposals that are politically palatable may be accepted, making the fiscal situation worse than before.

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