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February 20, 2013

Indian Economy|Public Finance

Budget Blues

By Nitin Desai


Mr. Chidambaram must be a worried man. A week from now he will present a budget which is expected to revive growth, contain inflation and reduce the current account deficit.  All this in a political environment where party colleagues are demanding a pre-election tax bonanza for the middle classes and more welfare giveaways.  Some of the balls that he has to juggle are bound to slip from his grasp and the real test is what he allows to fall and what he chooses to protect.

A great deal of attention will be focussed on the projected deficit.  He will almost certainly crack down on the expenditure side.  What one has to look for is where he holds down the increase –non-development expenditure, current development expenditures or capital spending.  Given the objective of reviving growth, one hopes that we will see some boost to public investment, particularly in infrastructure where private investment projects are langushing.

The bigger issue is whether the revenue projection is cooked to make the deficit figure look good.  One element in this is the assumed growth in revenues and anything much above 15% for this would be implausible, assuming 6%  GDP growth, 6% inflation and tax buoyancy of 1.25.  The other element in inflows is the proceeds of disinvestment. Mr. Chidambaran set up the National Investment Fund which was supposed to receive the proceeds from the sale of assets.  One wonders whether he will revive this very sensible procedure or count the sale of publc assets as a fungible resource under non-tax resources for meeting even current expenditures.

Given the very tight macro situation the FM's  room for manoeuvre on taxation is quite limited. There is the usual clamour for raising income tax exemption limits, etc. Hopefully he will resist this as there is no justification for it. He set the basic three rate structure of rates in his 1997 budget and that still holds fifteen years later. However the exemption limit and the rate at which the peak rate applies are now much higher than the 1997 levels adjusted for inflation.  Since 1997 the urban retail price index had gone up a little under three times. But the exemption limit has gone up five-fold and the income at which the peak rate applies has gone up more than six-fold. Till 2004 these two limits moved more or less in step with inflation; but since the UPA took over in 2004 a populist desire please the middle classes has led to an increase in these limits well beyond levels justified by inflation. (See the graph).

The FM  must resist the pressures from the salaried classes because there has been a bad erosion of the tax base in the lower tax brackets.  The big problem of tax compliance is the failure to rope in millions of middle income earners who stay out of the tax net altogether. Surjit Bhalla has demonstrated this convincingly in his calculations which suggest that only     10% of the assessees who ought to be in the lowest tax bracket actually pay tax. In fact his calculations suggest that compliance is better in he highest tax bracket. The increase in limits beyond what is justified by inflation adds to the problem by removing millions from the tax system. 

There is some clamour for a tax on the super rich, perhaps in the form of a surcharge on incomes beyond, say Rs. 1 crore.  One can sympathise with this because it does seem a major violation of the principle of progressive taxation if someone taking home Rs. 10 crore pays the nearly the same proportion of his income as tax as someone earning Rs 10 lakhs

There is one even more serious departure from tax-progression and that is in the tax treatment of dividends.  It has been argued that taxing dividends in the hands of the receiver amounts to double taxation as the corporation paying the dividend has already paid tax on its profits.  But corporations are independent juridical entities that enjoy public services like national defence and law and order independently of individuals. The Corporation Tax is their payment for these services they enjoy as corporations.  Taxing the profits they distribute does not amount to double taxation because the personal income tax is conceptually a payment for the public services that an individual uses.

We do tax dividends separately because we have a dividend distribution tax of about 16%.  But the tax is a uniform charge and, implicitly, a pensioner with a few thousand rupees of dividend income pays the same proportion of this as tax as India's richest individual and his family pay on the more than Rs. 1000 crores they receive as dividend income. This is a gross violation of the principle of tax progression. Collecting the dividend tax at source from corporations may have some advantages in reducing evasion. But some measure of progression can be introduced by requiring individuals to add dividends received to their taxable income and giving them credit for the tax collected at source in the form of the dividend distribution tax. The gains to the small dividend earner will be more than compensated by the much higher amounts paid by the billionaire owners.

There has also been some talk of an inheritance tax as we are one of the few capitalist countries that does not have one. A good idea but this, along with other proposals for soaking the rich, will run foul of the need to maintain a buoyant stock market in order to continue attracting the FII money sorely needed to cover the current account deficit and to facilitate disinvestment of public shareholding which is a crucial part of the fiscal deficit management.

On the balance of payments front there is little that can be done except for continuing with various export incentives and cracking down on gold imports.  Nearly 40% of the new gold demand in the country is for investment purposes and this demand is sensitive to prices and expectations about future gold prices and prices of competing assets like stocks and property. This is yet another reason for aiming at maintaining stock market buoyancy.

The budget will include pious promises about reforms. Perhaps the most important is what he can promise on the time frame for the introduction of the GST.  The greatest challenge however is that the FM has to lift the cloud of gloom that hangs over the economy






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