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Diwan-e-Khaas to Diwan-e-Aam 

Arvind Panagariya

Following the conclusion of the consultation period, the Kelkar taskforces have submitted their final reports. Criticisms in the press notwithstanding, Kelkar must be applauded for his innovation of the process of reform as well as the reform itself.

For the first time in India’s reform history, Kelkar began by placing his preliminary recommendations before the public in the form of consultation papers and actively sought its feedback. Though some reacted cynically arguing that the papers were merely trial balloons, having observed the process function efficiently in other countries during his various stints abroad, Kelkar genuinely wanted to move the policy making in India out of the diwan-e-khas into the diwan-e-aam.

And judging by the numerous e-mails and memorandums to the taskforces and opinion pieces and commentaries in print and electronic media, the experiment has been a resounding success. For their part, in the final reports, the taskforces have been sensitive to the genuine criticisms but without yielding to vested interests.

Thus, accepting the criticism that the original paper on direct taxes did not adequately address the needs of vulnerable groups, the final report has raised the basic exemption limit for senior citizens and widows to Rs 1,50,000 and retained the deduction of mortgage interest on loans for owner-occupied houses up to Rs 50,000. It has also retained tax rebates or deductions on educational expenses, medical expenses by senior citizens, treatment of handicapped dependents and permanent disability.

But on many other fronts, the taskforce has stood its ground. Despite considerable pressure, it has not withdrawn the recommendation to extend the tax base to agricultural income. In some ways, the ability to stand firm on this issue was the litmus test of the independence of the taskforce, which it has passed. As many as 98% of the genuine farmers do not have incomes exceeding the proposed basic exemption limit of Rs 1,00,000 and will therefore be exempt from any taxation. Much of the income beyond this exemption limit, which passes currently as agricultural income, is actually non-agricultural income and would be taxed under current laws if the tax authorities had enough resources to prove its true source. Once the exclusion of agricultural income is withdrawn, the disguise of agricultural income will no longer be available.

The taskforce has also largely stood behind its intention to put an end to the exemption raj thereby lending some sanity to the tax system. The plethora of exemptions that exists currently is truly staggering. 

Thus, during a recent visit to India, when I enquired of a few friends on the minimum tax with which an individual with an income of Rs 4,00,000 could get away, none could give a satisfactory answer. One of them, an up and coming chartered accountant, placed a thick book of more than 500 pages on personal income tax in my hands. It then took me only a few minutes to understand why the answer to my question was so difficult. The exemptions are so many and so complex that few individuals can actually understand them all. In all likelihood it is the wealthy, capable of hiring expensive chartered accountants and making the investments necessary to avail of the exemptions that are able to fully exploit the regime. Anyone unconvinced of this argument need only read paragraph 4.73 of the Kelkar direct-tax-taskforce report, which lists the countless savings-related tax incentive schemes currently available.

There is no doubt that some taxpayers will find their tax burden increased as a result of the proposed reforms. But these are also likely to be taxpayers in higher income brackets, able to take advantage of the multiplicity of the complex exemptions. For the large majority of the taxpayers, the increased exemption limit and reduced tax rate of 20% up to Rs 4,00,000 are bound to lower the tax liability. That the liability will fall on the average is readily seen from the calculations presented in the taskforce report.

Therefore, the widespread criticism in the press must be attributed partially to an insufficient appreciation of the proposals and partially to a successful lobbying effort by the well to do that fear increased tax once the exemption raj has been abolished.  The latter hypothesis finds some support in the disproportionately large attention paid by commentators to personal income tax reform even though these taxes account for less than 20% of the central tax revenues. In contrast, the proposals for the reform of indirect taxes, which account for the bulk of the tax revenue, have sailed through with relatively limited scrutiny.

Thus, an important indirect-tax policy change, proposed for the first time in the final report, has gone almost entirely unnoticed. The consultation paper had recommended three custom duty rates of 5, 10 and 20% by the year 2004-05. The final report carries this further, though with an unhappy twist. The report recommends bringing all tariff rates down to 10% or below by 2006-07 with basic raw materials being subject to a 5% duty, intermediate inputs to 8% duty and finished consumer goods to a 10% duty. 

Even though trade economists generally dislike escalation in duties according to the stages of production, in so far as the proposal achieves considerable compression of duties, it is to be welcomed.  These tariffs will likely yield a superior outcome than a uniform tariff rate of, say, 15%. Where the taskforce is to be taken to task, however, is in its grant of some major exceptions to this structure. Thus, it recommends a 20% duty on consumer durables, a 50% duty on motor vehicles and 150% duty on second-hand cars. These duties compromise both efficiency and equity by guaranteeing excessive effective protection to durables and automobiles at the expense of the consumer.

January 29, 2003