Make Corporates Less Loanly
A lowering of the corporate tax rate will provide promoters an incentive to bring in more equity
Version 3.0 of India’s new Direct Taxes Code is moving towards the finishing line. Hopefully, the task force steered by Arbind Modi will recommend progressive reforms in the new income-tax law to slash corporate and personal income-tax rates, scrap perverse incentives and adopt a sensible approach to the tax treatment of savings. The draft must be placed in public domain and the government should act on the recommendations based on the feedback from various stakeholders.
A low corporate tax rate of about 20% will not only make industry competitive but also prevent the build-up of bad loans in future. The total incidence of corporate tax — that includes the dividend distribution tax and other levies — is estimated now at over 50%. That leaves little retained earnings for corporates.
Gimme a Tax Break
The world over, a core issue in corporate tax reform is also about mitigating the tax bias against equity capital. India is no exception. The high cost of equity capital is one of the reasons why Indian promoters prefer to fund themselves through debt. They get a tax break (read: deduction) on interest, the cost of debt capital, whereas no relief is available on the cost of equity capital. This creates an artificial demand for debt.
Following the global financial crisis in 2008, many countries have tightened regulatory capital requirements for banks to bring down excessive corporate borrowings. Yet, tax systems in most countries act in the opposite direction: they provide incentives for corporations and households to borrow more than they otherwise would, raising macroeconomic stability risks, observed an IMF paper, Tax Policy, Leverage and Macroeconomic Stability, in October 2016.
Logically, ending the preferential tax treatment of debt would improve financial sector stability. While many countries have now limited the tax deductibility of interest, others have provided a deduction for equity costs. India has also set a limit on interest deductibility, but only for foreign debt. So, the bias against equity remains.
This distorts project financing and accentuates the problem of bad loans. Former RBI governor Raghuram Rajan recently suggested a flexible capital structure to lower the risk of bad loans for projects. “The more the risks, the more the equity component should be (genuine promoter equity, not borrowed equity, of course), and the greater the flexibility in the debt structure,” Rajan wrote in his note to a parliamentary committee on bank non-performing assets.
A cut in the corporate tax rate will provide an incentive for promoters to bring in equity. The other option is to scrap the dividend distribution tax charged on domestic companies. If either of the two is reduced, the government will need to look for alternative sources of revenue, which can be the goods and services tax (GST).
Despite its promise to cut basic cor- porate tax rate to 25% from 30%, the government has only done incremental tinkering. It should not dither over a cut now that it is confident that revenue collections from GST will rise. GST creates audit trails, and that will enlarge the base for direct taxes. And, collections will rise when tax rates are lowered.
Research studies show that labour shoulders a large portion of the cost of corporate tax. An estimate based on a study of cross-country data held that a 1% increase in corporate tax rates leads to a 0.5% decrease in wage rates. That hurts the economy too.
Let it Accumulate
However, the effective tax rate in India for bigger companies is close to 24% after exemptions. Exemptions must be scrapped as they mess up the tax system.
A lower tax rate will also end the practice of multinational companies using transfer prices to shift profits from India to countries that have low tax rates. This will bring down transfer pricing disputes.
India also has rules now to tax enterprises if economic activity take place here and value gets created in the country. This reinforces the case for lowering the tax rate. But the task force should not rock the boat on inter- national tax rules that are being debated globally.
A rate cut in personal income tax is also in order to raise compliance and reduce tax evasion. India should also move to a new regime for taxation of savings — where a savings scheme would be spared from taxation at the time of contribution and accumulation of the corpus and taxed only on withdrawal. But if the accumulated saving is reinvested on maturity, the corpus should again be exempt from tax.
This rule already applies in housing. If a person sells a house and invests the money in a new house, the capital gains is exempt from tax. The same rule should hold for all other assets. So, capital gains can be taxed only if a person sells assets to get money for consumption. This will leave more financial savings with a person and help create a self-financing social security system. Older fully tax-exempt schemes must be grandfathered.
The larger point is that tax policy reform must be far-reaching. India also needs a non-adversarial tax regime to bring certainty to businesses and individuals. But the government must not cherry-pick recommendations, eyeing electoral gains.
Hey, whaddya think! This is a loan