A MIDDLE PATH SET TO MAKE DIRECT TAXES CODE MORE PALATABLE FOR ALL STAKEHOLDERS 

DIRECT TAX CODE : Not so harsh, not so mild

THE BUDGET FOR THE NEXT FISCAL year is six months away. But a core finance ministry team is working overtime on a new piece of legislation to replace the five decade old Income Tax Act and enable the government to introduce it in the ongoing session of Parliament.
The Bill on the direct taxes code (DTC), now being vetted by the law ministry, is set to propose lower corporate and income tax rates to ease the burden on tax payers. Setting future tax rates is a prudent move as it will end uncertainty, bring stability and spare the government the obligation to specify tax rates in the Finance Bill every year.
The good news for tax payers is that the new law will be in simple English, shorter and easier to understand. But simplicity should be reflected in substance, not just the form. Tax laws should be simple and clean, based on sound economic principles to end ambiguity and reduce the scope for litigation. Presenting these laws to the taxpayer in simple language will then make eminent sense.
The new Bill provides a historic opportunity for the government to lower tax rates on the broadest possible base. Unfortunately, the tax base is expected to shrink as the government has abandoned many radical suggestions made in the original code.
Prominent among them is the recommendation to tax savings schemes at maturity or the exempt exempt tax (EET) method for taxing long term savings schemes in jargon. The government has cited problems of putting in place a social security system in the near future, logistical and technological challenges as the reasons for shunning the proposal.
Today, most savings schemes are exempt from tax at all three stages contribution, accumulation and withdrawals. Several expert committees have held that the EEE method of tax treatment is distortionary, resulting in economic inefficiency and inequity. The government should provide a road map for switching to the EET method of tax treatment at least in the medium term. Technological challenges can be tackled as the country has the software prowess to address them.
Many tax incentives for individual tax payers, including the Rs 1.5 lakh deduction on the interest paid on home loans, will be retained. The government has justified the tax-break, saying it will promote investments in housing. However, this goes against the principle of phasing out open-ended exemptions. A time-frame to end exemptions would, therefore, be in order.
Similarly, the proposed changes in the tax treatment of capital gains signal a policy flip-flop. The Bill is set to bring back capital gains tax at normal rates, subject to some deductions. Exemptions hemmed with conditions will only make tax laws more complex and this is avoidable.
There may not be many surprises either on the tax policies for companies. The government has dropped the minimum alternate tax proposed on gross assets. Although this was sound in principle ,the implications were worrying for companies. It has also watered-down the provisions in the original code on ending tax breaks to companies housed in special economic zones. Such exemptions lead to tax evasion and avoidance and add to the collection costs.
A dilution of the provisions will shrink the tax base from the level envisaged in the original DTC, making it tough for the government to lower corporate tax to 25% at one go or significantly hike the threshold levels on personal income tax.
Distortions in tax policies, perhaps, did not matter much when India was a closed economy. Not any more. Low tax rates and simple tax laws are a must to make India an attractive investment destination. The government should outline the road-map for tax policy reforms in the Bill.

Economic Times, New Delhi, 05-08-2010.