In defence of Kelkar

The draft report on direct taxes of the task force headed by Dr Vijay Kelkar has drawn much undeserved and ill-informed criticism. This is unfortunate, as the report presents a coherent vision of a modern and transparent tax regime and administration, which is simple, equitable and treats tax-paying citizens with dignity. The provisions relating to personal taxation now are a veritable maze, and no ordinary taxpayer can file his returns without the help of professional tax intermediaries. The personal taxation regime is a tax-payer's nightmare and a chartered accountant's delight. Any reform that puts the taxpayer back in charge cannot be dubbed anti-middle class. However, the proposals in the report may require some tweaking to address a few political sensitivities, particularly in view of the approaching elections. Let us look at some of the points made against the report. First, it has been accused of putting a greater tax burden on the middle class, particularly the salaried. Second, that it narrows the tax base. Third, that it discourages savings. Fourth, that it would undermine investment in housing by withdrawing the huge deductions permitted for interest on self-occupied housing. The fifth aspect relates to taxation of agricultural income. The sixth relates to taxation of dividends and capital gains. With regard to the burden on the middle class, it is obvious that no one with an annual income of up to Rs 1 lakh will be worse off than before. A person with an income of Rs 1 lakh will now have a tax saving of Rs 3,000, or a higher disposable income of Rs 10,000. As we move from Rs 1 lakh to Rs 1.75 lakh, the marginal tax rate at 20 per cent is the same as before (after taking into account the standard deduction), and the aggregate tax incidence is lower by Rs 4,000. However, in the current system by saving in specified instruments, the taxpayer can reduce his tax liability by up to Rs 20,000. At an income of Rs 1.75 lakh with a saving of Rs 90,000 (51 per cent propensity to save), under the current system, the tax liability is zero, but the disposable income is only Rs 85,000. However, these will become Rs 15,000 and Rs 1,60,000 once the proposals are implemented. So, the proposals, to use the words of the Finance Minister, Mr Jaswant Singh, do put more money into the pockets of housewives, albeit at a modest cost. Recognising that the households would save for long-term security (Section 80 CC) and incur merit expenditure on health insurance (Section 80 D) and education (Section 80 E), it has been proposed to lower the tax incidence to around Rs 10,000. However, the point to consider is whether a person earning Rs 1.75 lakh per annum should not contribute at all to taxes, as is the case now. This also shows that the report actually widens the effective tax base rather than narrowing it. As we go from Rs 1.75 lakh to Rs 4 lakh, the marginal tax rate in the report is lower than the current rate of 30 per cent. At Rs 1.8 lakh, the benefit of the savings provisions to achieve nil tax is exhausted, and thereafter the marginal tax rises more rapidly and the difference in net tax incidence reduces uniformly from Rs 16,000 to zero at an income of Rs 3.35 lakh (after taking into account the blip in the standard deduction). At that income the tax incidence is the same, but the disposable income is lower by Rs 1 lakh under the current system. Thereafter, the tax incidence is even higher under the current system. Therefore, to meet the critics of the report half-way, could a way be found to lessen the net tax incidence on the income category of Rs1 lakh to Rs 3.35 lakh? The answer is yes. Two things can be done. The standard deduction of Rs 20, 000 for the salaried class up to incomes of Rs 4 lakh can be retained (no more slabs and rates are required). The limit for rebate on pension products such as the Jeevan Suraksha can be increased from Rs 10, 000 to Rs 30,000. This will provide a relief of Rs 6,000, and the cost of higher disposable income of up to Rs 1 lakh for the household will drop to less than Rs 10,000. That is, just 10 per cent. And with the proposals to remove capital gains on equity the households will be able to earn higher returns in the long run through the freedom of asset allocation that the report provides, and save on the tax incidence too. On the criticism that the report discourages savings, the truth is that the report eliminates forced savings for certain sectors. This is to make the savings flow into the most productive channel in a competitive manner. The current provisions relating to tax rebates for savings essentially act as a SLR on individuals. When the SLR requirement on banks has been done away with as a part of the reform process, why should individual savings continue to be so pre-empted? By placing greater disposable income in the hands of the taxpayer, the report puts him in the driver's seat on his savings and investment decisions. And the options today are much wider with capital market reforms in debt and equity markets, and the entry of many new intermediaries such as mutual funds and private sector banks. It also spares us from the ridiculous fiction of long-term savings through instruments that have a maturity period of three years. Also, the marginal contribution to national savings of the elaborate tax exemption system is nil, and the transaction costs it entails are considerable. It is a national waste and, as a poor nation, we cannot afford it. The report has been targeted for its recommendations on phasing out interest deductions up to Rs 1.5 lakh per annum on loan taken for a self-occupied house. It is one of the key principles of taxation that if income from a source is not taxable then expenditure on that account are also non-deductible. In our income-tax law, the treatment of a self-occupied house has been an exception to this. While the value of the house for tax purposes is taken as nil, deductions of interest on a loan were allowed up to Rs 30,000 per annum and, in the last few years, were raised to Rs 1.5 lakh. In any case, few in the middle-class would be able to afford a house for which the loan component alone is in excess of Rs 15 lakh. Under the prudence criteria used by the housing finance industry, in order to be eligible for a loan of Rs 15 lakh, a person would need to be earning in excess of Rs 5 lakh per annum. It is, therefore, ironical that such a high limit is being justified in the name of the middle-class. If one were to take the repayment capacity of an income of Rs 3 lakh per annum, the interest deduction limit should be no more than Rs 90,000. As such, at least the first phase of the reduction proposed by the task force is fully justified and should not only be immediately adopted but also made more aggressive by lowering the amount to Rs 75,000. As regards its impact on the housing sector demand, which is already partly cushioned by the lowering of interest rates, it can be more than mitigated through some supply side initiatives such as action on the long-stalled urban land ceilings and rent control Acts. There has been much breast-beating on the proposed taxation of the agricultural income of non-agriculturists. The task force has only sought to plug a loophole, and create a level playing field for all asset classes. This should be welcomed. Giving favourable tax treatment to the incomes of absentee landlords is unacceptable in any civil society. In fact, the current treatment of such income has spouted the abhorrent `farmhouse culture' and has contributed to dispossession of genuine farmers. The taxing of farmers' income is a long-term issue for which the process of consultations and constitutional amendments would have to be completed, before appropriate modalities are adopted. The Task Force recommends abolition of tax on dividends, both at the distribution stage and in the hands of the investor, and long-term capital gains on equity. This is to avoid double taxation. Once corporate income has been taxed, further taxation is unwarranted. Seen in the context of the gyrations on the issue in the last few Budgets, this is a masterstroke. However, a few issues need to be addressed. Going by the undisputed logic of the Task Force, there is no case even for taxation of short-term capital gains in equity. It would, therefore, be consistent to abolish all capital gains tax on equity and instead have a small transaction tax on sale purchase transaction of equity. If capital gains tax on equity is abolished without similar treatment to equity mutual funds it would cause disintermediation, which is not in the interest of small investors. However, within the mutual funds arena, there would be arguments for equal treatment of debt and equity funds. Further, once long-term gains are made tax exempt, there would be no avenues for booking long-term losses, which in view of the moribund markets of the last decade most investors are likely to have. If this is not explicitly addressed it may lead to greater investor anger, rather than gratitude. Therefore, a transition arrangement to enable investors to clean up their portfolio needs to be put in place. One way this can be done is by providing that losses can be set off against short-term gains (in case these are not exempted). Alternatively, a limit of, say Rs 1 lakh per annum, for deduction of long-term losses from salary and house income could be made available for a period of three years. To sum up, the Kelkar report has a comprehensive, bold and innovative programme of reforms for our highly fractured personal taxation regime.