Make Cor­po­rates Less Loanly

A low­er­ing of the cor­po­rate tax rate will pro­vide pro­mot­ers an in­cen­tive to bring in more eq­uity

The Economic Times - - The Edit Page - Hema Ra­makr­ish­nan

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

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