A tax system for the 21st century

In less than two months, the Kelkar taskforces on direct and indirect taxes have spoken. They propose to overhaul the Indian tax system. The question is whether Jaswant Singh will show the necessary courage.


I have argued in this column and elsewhere that with the Indian economy now producing goods and services worth approximately Rs 20,00,000 crore annually, policymaking has become too complex to be left exclusively to career bureaucrats. The bureaucrat's instinct is to give priority to putting out daily fires while lighting a few of his own; the specialist is eager to address issues of architecture and engineering of policy.

Therefore, when Jaswant Singh appointed Vijay Kelkar as his advisor within days of taking charge as finance minister, he was signalling his intention to repeat the success he had achieved as the external affairs minister.  Kelkar is not only a first-rate economist with a Ph D in economics from the University of California, Berkeley but also a long-time insider with a keen sense of how to design good policy in the context of the prevailing political constraints. 

As his first assignment, Jaswant Singh entrusted Kelkar with the job of drawing a blueprint of India's future tax system with the help of two taskforces, one on direct taxes and the other on indirect taxes. Acting with lightening speed, Kelkar has produced preliminary draft proposals in less than two months. The proposals can now be found on the finance ministry website in the form of two consultation papers with an invitation to the public to give feedback before the taskforces carve their recommendations in stone. 

Space limitations preclude detailed examination of the papers spanning over 370 pages. But three key features may be highlighted. First, the taskforces seek increased transparency in the tax system. Currently, there is a plethora of tax rates and exemptions in all areas of taxation. The taskforces propose to reduce them as much as possible provided they do not unduly compromise the efficiency and equity principles of taxation or lead to a revenue loss. They particularly target what Kelkar calls the "exemption raj," evoking the images of the dreaded "licence raj" of 1980s and before. 

Thus, for example, the paper on direct taxation recommends the elimination of the standard deduction; tax rebates for savings, senior citizens and women; income based deductions for interest income and dividends; exemption in respect of interest income from bonds, securities and debentures; and deduction for mortgage interest on loans for owner-occupied dwelling. It proposes to replace them by an increase in the generalised exemption limit from Rs 50,000 to Rs 1,00,000 for all individual and HUF taxpayers. The paper also proposes to replace the number of tax slabs from three to two. Incomes between Rs 1,00,000 and Rs 4,00,000 are to be taxed at the rate of 20% and those above Rs. 4, 00,000 at 30%.

The taskforce on indirect taxation likewise proposes eliminating all import taxes and surcharges other than the basic and anti-dumping/safeguards duties. It recommends bringing down the number of tariff rates to three: 5, 10 and 20%. As regards domestic taxes, the taskforce recommends replacing all levies by the Cenvat, proposing to tax all items other than food, agricultural products and tobacco at 16%. It also recommends eliminating numerous tax exemptions including those to small-scale units with annual turnover exceeding Rs 50 lakh.

The second distinguishing feature of the papers is their frontal attack on the transactions costs at all points of contact between taxpayers and tax collectors. The twin papers rightly view tax policy and tax administration as intimately linked: fewer exemptions and tax rates mean fewer disputes and better administration means greater efficiency of the tax policy. But the papers go farther in suggesting numerous steps directly aimed at improving the tax administration.

The paper on direct taxation recommends that tax administration move away from punishing (by harassment) those who pay taxes and towards detection and prosecution of the non-compliant and providing taxpayer services (for example, taxpayers' clinics) aimed at encouraging voluntary compliance. In a similar vein, the taskforce on indirect taxation offers detailed suggestions on the reform of indirect-tax administration on all fronts. The bulk of the 276-pages-long paper is, in fact, devoted to this task.

The final important feature of the proposed tax system is the broadening of the tax base so as to keep the tax rates low. In this area, the taskforce on direct taxation takes the commendable step of recommending the inclusion of agricultural income into the tax base. Anticipating possible opposition in the name of protecting the interests of poor farmers, it rightly notes that most genuine agricultural farmers will be automatically excluded from taxation under the newly proposed exemption limit of Rs 1,00,000. The tax will, therefore, target the agricultural income of non-farmers. The taskforce on indirect taxes likewise proposes to broaden the tax base by bringing many currently untaxed services into the tax net. The Govinda Rao Committee has provided the blueprint for this measure earlier and it is a reform waiting to happen.

A key chapter in the paper on indirect taxation offers a large number of specific, urgently needed reforms in the area of trade facilitation. The paper cites a study by the Export-Import Bank according to which transactions costs facing our exports are as much as 8 to 10% of the value of exports. Even cutting these costs into half would save the country and exporters several thousand crore rupees. The paper makes a credible case that this can indeed be accomplished.

The taskforce on direct taxes rightly expresses the concern that "the efficacy of its recommendations is likely to be seriously vitiated if individual components are selectively accepted or rejected" and that the "success of tax reform efforts depends on their implementation in an integrated manner."

The critical question therefore is whether the finance minister will aggressively move to implement the package, leaving a modern tax system as yet another of his legacies to the future generations.