India´s Union Budget: next steps on road to reform

February 15, 2013

The Finance Minister needs to announce structural changes that will release India’s growth potential

By: Sudhir Kapadia, National Tax Leader, Ernst & Young, India

As India’s Finance Minister (FM), P. Chidambaram, stands up in Parliament on 28 February 2013 to present the Budget, across the spectrum of India Inc, the International Monetary Fund (IMF), credit rating agencies and foreign investors will be watching with both a sense of weariness as well as cautious optimism.

In its recent report, released on 6 February 2013, the IMF has clearly laid the blame for the slowdown in India’s GDP growth at India’s doorstep, noting that global factors have played only a peripheral role in this slowdown. The report has cited structural supply side constraints, falling infrastructure and corporate investments as the main drivers for India’s slower growth rate of GDP at 6%–7% now, versus the potential growth rate of 7.5%–8% projected earlier.

The report also notes the heightened inflation and high revenue and fiscal deficits as huge challenges facing the Government.

Earlier reports in India by an Expert Committee on Fiscal Consolidation (Kelkar Committee) and the Planning Commission too have noted the urgent need to take bold policy decisions, such as speedy implementation of infrastructure projects and a reduction in subsidies for India to get back to a higher growth trajectory.

Against this backdrop, we analyze below the measures on taxes that the Government may consider introducing in Budget 2013.

Direct taxes

Corporate tax

All indications are the FM will not be changing the current corporate tax rate of 33%. However, it is likely that he may consider an increase in the minimum alternate tax (MAT) rate from the existing 18% to 20%, on the basis that the effective tax rate of Indian companies across the spectrum is currently around 23%–24%.

The other important change that the FM may consider is to transition from the current system of profit-linked incentives to capital-based allowances, as has been provided in the proposed Direct Tax Code (DTC) which has yet to come up before Parliament. This may serve a twin purpose of increasing short-term revenues as well as signaling the Government’s intent to encourage capital formation in the economy.

Personal tax

As has been the case in many Western economies, there have been definite moves to tax the “super rich” in India at higher marginal rates than the currently prevailing one of 31%. In this regard, the FM may consider first increasing the 31% rate at the margin to 33% and harmonizing it with the corporate tax rate, and then to provide for a still higher rate to say 40% for incomes exceeding US$200,000.

While such a move is not expected to increase the direct tax revenues significantly, given the relatively small number of taxpayers in India reporting such high incomes, it may be a tactical move – an attempt to justify other belt-tightening measures by also making the super rich share part of the pain and sacrifice. The other area of debate is around taxation of dividends in the hands of high-income shareholders.

Under the current scheme, companies pay dividend distribution tax (DDT) at 16% and, consequently, the shareholders receiving dividends do not suffer personal tax. As a result, high net worth individuals and promoters receiving large dividends personal tax. The FM may therefore consider an additional tax for high-income dividends earners over and above the DDT paid by the company.

Capital gains

Currently, long-term capital gains on listed securities are exempt from tax. The Shome Committee has recommended abolition of short-term capital gains tax on listed securities too, on the basis that foreign portfolio investors make investments via Mauritius to prevent short-term capital gains arising in India, thus creating an uneven playing field vis-à-vis domestic investors.

By exempting short-term capital gains from taxation, not only will domestic investors be brought on par with foreign investors, but the use of Mauritius will become largely redundant in this context in view of the tax exemption. It remains to be seen whether the FM will propose such a bold measure, but if he does, it is expected to be a tremendous boost to the capital markets and consequently the much-needed foreign investment in this sphere.

Indirect tax

Due to the inflationary impact of the increase in indirect tax rates, the FM is expected to retain the current rates of existing duties and service tax. However, there is a possibility that the FM will introduce measures to expand the tax base, e.g., by removing the exemptions to about 240 items in excise law and further reducing the negative list in service tax law to bring even more services into the tax net.

Budget 2013, thus, urgently needs to address structural reforms that should be implemented immediately, as well as fiscal consolidation to contain the fiscal deficit within 5.3% of GDP as projected. It will need to be low on rhetoric and high on actionable steps to achieve the milestones laid out by the Kelkar Committee and Planning Commission to meet the aspirations of an increasingly young, energetic but restless India.

Let us hope that the current sense of weariness quickly gives way to cautious optimism and, ultimately, deliverance from the quagmire of the 6.7% GDP growth rate. India deserves much more than this. The good news is that P. Chidambaram knows this very well.

The question is: will he deliver? The world will know on 28 February 2013.

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