Optimal Tax Regime for achieving a 5 trillion Dollar Economy

Tax System plays an important role in shaping the growth trajectory of an Economy. This Article published in FORUM VIEWS Magazine (BBF) is a loud thinking on the features of an Optimal Tax Regime for achieving a 5 trillion Dollar Economy. (Views are purely Personal) Link: https://brokersforumofindia.com/assets/magazines/pdfs/2021/NL%20May%202021.pdf

Optimal Tax Regime for achieving a 5 trillion Dollar Economy

 A.             Introduction:

Due to slowdown induced by COVID19 pandemic, Nominal Gross Domestic Product in the year 2020-21 registered negative growth rate. It is estimated to be about ?196 trillion (US$ 2.7 Tn), down from ?203.5 trillion (US$ 2.8 Tn) during 2019-20. The national ambition enunciated by the Hon’ble Prime Minister of reaching GDP of US$ 5 trillion by Fiscal 2025 has been thwarted by the crunch. Exactly at the time when the flexibilities of the Economy were about to be reaped, the COVID19 pandemic dealt an unfortunate blow.

As sure as the spring will follow the winter, prosperity and economic growth will follow recession – Bo Bennette.

India has bounced back. The International Monetary Fund (IMF) in its latest World Economic Outlook has projected robust growth rate of 11.5% for India in 2021 - making it the only major economy in the world to register double-digit growth amidst the COVID19-triggered global economic slump.

Simple maths would tell, an average real annual growth rate in GDP of 8-11% coupled with healthy inflation of 4-5% (Aggregating to nominal growth of 12-16%) between Fiscal 2021-22 to 2025-26/2026-27 would take us to the targeted GDP of $5 Tn.

The tricky part is how to achieve the growth rate and trickier part is how to sustain it for 5 years!

As the Economic Survey of 2018 put it, a virtuous feedback loop of 3 macro variables Savings → Investment → Exports, leading to Growth would act as the “central driver” for the requisite fast-paced growth.

This article posits that Direct Taxes have immense impact on savings, investment as well as exports. As a fiscal policy instrument, it can act as a trigger of growth. Also, being a principal item of cost, taxes may act as constraint. Optimal tax policy aims at maximising the trigger effect and minimizing the inhibitor effects of Direct taxes. Hence, direct taxes like Corporate, Personal Income Tax, Levies like Equalisation Levy etc. can be designed and targeted to assist and sustain the virtuous cycle among the above 3 macro-economic variables.

The Indian economy has become more formalised after demonetization and introduction of Goods and Services Tax. Hence, the impact of direct taxes on saving and investment behaviour would be more pronounced.

B.             Theoretical Underpinning:

The key to Growth is enhanced savings leading to higher investment and Capital Formation. Savings and capital formation requires leaving more surplus with the savers-investors and Enterprises and Wealth Creators for re-investment and growth.

Noted Economist, James Mirrlees, in his 2006 research paper on optimal tax literature advocated that the marginal tax rate (Average tax rate may be high!) on the topmost income should be negligible/zero for highest welfare and productivity!

The Corporate Tax Reforms of India undertaken by the Government during September 2019 has been a step in right direction in terms of lowering of Maximum Marginal Rate taxation. With the lowering of the tax rates, the Laffer Curve Effect in terms of lower tax rates leading to healthy tax revenue has fruitioned in preceding years (Factoring out COVID-19 shock). The Tax system is becoming broad-based, buoyant, flexible, elastic – all supportive of high growth rate.

C.             Basic Premise:

Shedding the age-old negative connotation of taxes being akin to death and its arduous certainty – it can be tweaked to act as an enabling instrument of Public Policy.

The Tax Department of India has already made its role clear as a Service provider and a facilitator of growth and development.

D.             Sectoral Approach to Optimal Tax Administration:

From a sectoral perspective, Agriculture has 15% contribution. However, it is mostly tax exempt under section 10(1) of the Indian Income Tax Act, 1961. Hence, the Services (60%) and Manufacturing/Industrial Sector (25%) are the suitable candidates for tax incentives.

Manufacturing is the most crucial activity. There is a need for unlocking the unlimited potential of Indian manufacturing sector. Tax must act as a present, but beneficial instrument. A vibrant economy requires high velocity growth and expansion of domestic industrial base. The approvals under the Make in India Mission and related pledges and Memoranda of Understanding would do well to enjoy tax exemption, at least during the initial stages of investment and incubation and subsequent survival and growth period of 5-10 years.

Similarly, there is a great necessity for unleashing the dynamism of Services sector. It requires a conducive ecosystem for Start-up and exemption from taxation during the incubation period.

Further, investment vehicles like Venture Capital Fund (VCFs), Real Estate Investment Trusts (REITs)/Infrastructure Investment trusts (InvITs) are required to enjoy tax exemption, but purely on the ground of re-investment of tax-free profits.

The transactions in primary and secondary markets face several taxes like Capital Gain Tax, Securities Transaction Tax, GST etc. The take-off of Indian economy will necessitate a reformed taxation of the funding, investment and financing channels.

E.             MNE Tax Administration:

Double digit growth rates cannot be sustained under autarky. Both import and exports as well as inward investments and outbound investments need to be boosted.

It is true that cross-border companies have more flexibility in managing their headline tax rate and tax exposure. However, for the FDI/FII/FPI investment, there is a necessity for simplified and attractive MNE taxation. Clarification and Position is required to be enunciated on the pressing issues of Base Erosion and Profit Shifting (BEPS) and repatriation of funds. Attractive tax packages with tightly tied investment/employment parameters will attract the MNCs to shift base to India and substitute destination like China, South East Asia etc.

In the International Tax administration arena, simplification of rules of Fees for Technical Services (FTS), Reimbursements, Transfer Pricing (TP) documentation requirements etc. would make the country a more attractive investment destination.

The Mutual Agreement Procedures (MAP) for tax dispute resolution mechanism available to the foreign taxpayers under the DTAAs for resolving disputes is required to be strengthened. Similarly, Advance Pricing Agreements (APA) being the procedural agreement between one or more taxpayers and tax authorities that aim to avoid transfer pricing disputes, requires to be further streamlined.

Taxation of the Digital Economy is a vexatious issue. Any emerging controversy can be done away with clearer and definite rules regarding tax base and levy.

F.             Tax and Export Oriented Enterprises:

Present Global environment is unsupportive and obstructive, and closing of economies due to COVID-19 stress and there has been shrinkage of trade. Under such scenario, cost-competitiveness can be improved with enhanced tax deductions and input credits.

Reinvigoration of the Indian Income Tax Act provisions of section 10A/10AA architecture for genuine Special Economic Zones enterprises/Export Oriented Units would enhance the competitiveness in terms of costing and ease of doing business.

As per Michael Porter’s Diamond Model the government should encourage and push companies to raise their aspirations and move to even higher levels of competitiveness.

An optimal tax regime for growth phase has to act as a catalyst and may consider stepping back where necessary and always remain flexible at desirable places so that the nation attains competitive advantage.

G.            Transparency and Ease-of-doing Business:

Tax system and tax administration is a major component of Ease-of-doing business. The optimal tax regime would address the following:

[a] Reduction in Compliance Cost:

Not only tax itself, but the compliance procedures pose challenges at times. There has been moves towards reduction of tax compliance burden like enhancement of turnover limits for Audit, broad-basing of presumptive tax schemes, pre-filled Tax returns. Further reforms like simpler Tax Forms, rejigging the Personal Income Tax rate slabs etc.

[b] On-going Reforms in Direct Tax Administration:

On 13th September 2020, the Hon’ble Prime Minister launched the ‘Transparent Taxation’ platform for faceless assessment of taxpayers and the Rights’ Charter for the taxpayers.

Under the present Government policy, the tax administration is on path to Discretion-free and fair tax Scrutiny and Audits. Such a tax regime is supportive of growth.

The case selection for audit/scrutiny have been predicated on Data analysis and Risk-based selections. The future tax administration will utilise Big Data and superior data mining technology to catch the tax evaders, while honouring the vast majority that comprises of honest taxpayers and law-abiding citizens.

Long winding tax Litigations lock up the resources of enterprises. Simplification and speeding up of litigation system and litigation management is overdue. The Faceless First Appellate system and Faceless Tax Appellate Tribunals with time limit for conclusion of proceedings would go a long way in releasing the locked up taxes and conferring certainty.

A dynamic tax system would entail certainty in tax areas and rates. As a matter of policy, retrospective amendments to tax law have been completely disbanded. Avoidance of Sharp changes in law with regards to tax base or tax rates would go a long way in creating a conducive environment for greater investment and growth.

[c] Simplification of Law:

A further step towards implication of the Domestic Tax Act by way of the Direct Tax Code (DTC) would be a welcome move for simplification and cutting of compliance costs.

[d] Greater Use of Technology & Innovation:

Presently most interaction between Tax Administration and the Tax payer have become on-line, digital. The dealings with the Tax Department in terms of communications, grievance redressal, Assessments, etc. have been made on-line. There is further scope to dynamize the Tax Administration-Business interface by way of adoption of technological advances like the Blockchain etc. The use of digital platforms and wallets like Paytm, RuPay, etc. the future tax payments, TDS would go a long way in making the levy and collection customer-friendly.

[e] Doing away with Distortionary Taxes:

Several sections and provisions of the Tax Act which create distortions in the taxpayers’ choice and behaviour are required to be examined and amended towards the proper direction.

These steps would take our tax regime towards further finesse in boosting growth.

H.             Incentives for Personal Savings and Investment:

A higher limit of tax deductible investment avenues under section 80C etc. would also go a long way in inculcating saving habits into salaried class and making funds available for investment.

I.                Strict Measures to curb Tax Evasion:

The Honest must be protected while the unscrupulous tax evaders must face due strict legal consequences. Any intrusive actions like searches & seizure actions or surveys are to be purely information based, coordination of Direct Taxes and GST databases and data-driven actions. The deterrence effect of the intrusive actions needs to be propagated through conclusive investigations and successful convictions.

J.              Distributive Justice in a Development-oriented State:

The full potential of our Country will be achieved only when the social objectives of upliftment of the poor and asset-less populace are made to go hand in hand with growth. Special tax provisions and benefits for businesses with greater employment are required to be worked into the Tax Law.

The trickle-down effect may not work automatically. A welfare country like India will need to pass on the benefits growth in terms of tax relaxations to weaker sections like women, senior citizens, salaried sections, etc.

Further, presently there is concentrated growth in few States like Maharashtra, Karnataka, Tamil Nadu, Gujarat etc. High growth would entail the broad-basing of growth phenomenon across whole of India. The proper focus, administration and extension of regional tax incentives like Section 10C/80IC deduction of the Income Tax Act to the other emerging states is a sine qua non.

Taxation should be an efficient instrument for addressing personal as well as regional income inequality to fully realise the potential of the vast workforce of India.

K.             Insolvency and Exit Strategies:

The Insolvency and Bankruptcy Code (IBC) has ushered new era in the field of dispute resolution. With genuine business/entrepreneurial failures, large tax arrears create issues of resolution and/or exit since Tax Department is an entitled operational creditor. Further, the waiver/write-backs also create potential tax events which require clarification. Hence, there is a necessity to rationalise the Tax Law in consonance with the principles of the IBC for achieving the full potential of failed but genuine enterprises. Such an action would entail flexible laws for future payment of tax arrears.

L.             Mergers & Acquisitions:

Mergers and acquisition (M&A) activities are the hallmark of business restructuring and transformation. The growth of corporates is predicated upon M&A activities. Such operations are envisaged to be tax neutral and the optimal tax policy is required to be geared up to incentivise the M&A activities.

M.            Culture of Honesty, Paying taxes and Voluntarity:

Taxes are contribution towards progress of the nation. The Taxpayers' Charter of 2020 provides for rights and responsibilities of the taxpayers. The Tax Department has taken up the pledge to be fair, transparent, decisive, courteous and respectful.

At the same time, responsibility has been fastened with the taxpayers to be honest and compliant, pay due taxes in due time.

A leading economy would require the citizens to be honest and aware of rights as well as duties to the nation and voluntarily pay taxes for the growth of the country.

N.             Summing Up:

In the present world of VUCA, India has the potential to reach the goal of $5 Tn. GDP in the coming 5/6 years despite the COVID-19 shock. For this, the Industry, Society, Policy, and Strategy are perfectly aligned at present.

The tax system, being a part of the policy structure has been strategized for optimality and growth potential. The factors as discussed would incentivize as well as support the achievement of the $5 Tn. economy dream.

(Views expressed by the Author are purely Personal)

PS: Thanks to Dr. Vispi Bhatena, for the immense support.