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3.1 Ramifications of Tax Policy for Tax Administration
By the late 1960s and early 1970s, Scandinavia, the United Kingdom and other developed countries, as well as many developing nations, had legislated multiple and high individual income tax rates. Among the highest was India’s, where it was well over 95 per cent. Such high and multiple rates not only
made tax administration very difficult, but also led to a state, especially in
developed countries, where income tax evasion became widely accepted as standard behaviour.
During this era, corporate income tax rates were also very high with most countries legislating rates between 50 per cent and 60 per cent.
The expected negative ramification of such high marginal tax rates was that income tax became replete with exemptions, allowances, deductions and incentives. What started as sectoral and specific relief from high taxes were
soon extended to facilitate and accommodate social or development goals. It was rarely analysed whether such tax exemptions actually achieved the desired objectives. But these developed lives of their own and, in most countries, inevitably multiplied over time — driven by interests of specific power
groups at different points of time. India was no exemption. Thus, over and above the personal exemption or threshold, the individual income tax base became eroded by explicit deductions for household size
(which has been used both as an allowance in some countries and as a disincentive in others), education expenses and loans (as social objective), life insurance
(both for social security and saving objectives), and particular saving instruments
such is government securities or small banks such as post-office saving banks. It
also excluded implicit income from owner occupied housing, sometimes pecuniary income from second homes, agriculture income and so on, across the world. In some Asian and Latin American countries, certain sources of income such as interest, dividends, and gains from capital were exempted altogether.
Understandably, in not a few countries including some developed ones, individual income tax came to be popularly known as a ‘voluntary tax’. The corporate income tax base also became analogously eroded.
Accelerated depreciation for select activities, tax incentives for employment generation or capital equipment, tax holidays for export-oriented industry,
breaks for backward region development, small-scale industry and environmental investment, and the like — these all became a part of the fiscal landscape of India. Often, these exemptions led to inequitable taxation. For example, the
7 This section is heavily drawn from
Parthasarathi Shome, India’s Fiscal Matters, Oxford University Press, New Delhi (2002).
jewellery industry produced very large incomes, but contributed to little
revenue.
In other instances, it led to excessive imports of unused accessories such as windmills or solar energy panels. Such examples can be multiplied. While some countries attempted to narrow the scope of incentives over
time, many failed to carry out comprehensive reform in tax policy and concomitant tax administration. In most part, this reflected the power of
lobbies and political economy constraints associated with removing a vast spectrum of incentives in one go. However, the incremental approach to reform is also
fraught with dangeRs.The electoral cycle of democracies make it very difficult for
even reformist governments to credibly pre-commit to a time-table and schedule of reforms. More often than not, this has resulted in the original objectives
being diluted — only to recreate new opacity in the ‘reformed’ tax system.
A few facts need to be stated at this stage — facts that are common knowledge to most experts in fiscal policy.
· First, there is hardly any evidence to prove that
tax incentives have, per se, increased investment or saving — for which these incentives were devised.
· Second, the corollary has been proven very often
— namely, that scaling back of tax incentives and exemptions have almost always had a positive effect on tax policy, tax revenue, tax compliance and tax administration.
· Third, decreasing the intensity of tax incentives
automatically translates to a tax expenditure. Thus, even if gross tax revenues remained the same, the net tax revenue would necessarily be higher.
· Fourth, the other important implication of
"exemption raj" tax regime is the loss of effective parliamentary oversight as the resultant "tax expenditure" are not transparent and not amenable to the C&AG audit ; a clear laws to democratic governance.
· Fifth, the tax incentives create antagonistic
tension between the tax administrator and the taxpayer as the tax system is being asked to meet multiple objectives such as support to R&D, Promotion of backward area etc. This becomes a source of litigation.
· Sixth, fewer the tax incentives, the less is the
discretionary space available to tax administrators to interpret the law or executive statutes.
It has been repeatedly emphasised to this Task Force that the ‘control over the provision of tax incentives to a particular investor’ by ‘government officials’ is a ‘major instrument that makes corruption possible’ — which often results in unwarranted discretion in the hands of officials, and militates against arm’s length transactions.
The results of the income tax laws due to the "exemption raj", comprising of complex, allowance and exemption, are two-fold. For honest taxpayers, on
the one hand, filing the income tax return continues to be an annual exercise in complexity, and an uncomfortable fear of the assessment by the tax administrator that is to follow. On the other, a direct result of the
complexity in the tax structure is the difficulty faced by tax administrators in carrying out
initial assessments, as well as to execute selective audit functions.
By the beginning of the 1980s, things had begun to change — starting with developed countries and then spreading to globalising developing
nations.
By the mid-1990s, the structure, design and enforcement of both individual
and corporate income taxes underwent major changes. Earlier ideological
objectives were substituted by considerations of incentive compatibility,
reasonableness, administrative feasibility, stability and the credibility of fair
enforcement.
The first step in reforming the income tax structure was reducing the number of as well as the level of rates. By the mid-1990s, many developing countries had emerged from the reform process having legislated individual income tax structures with significantly lower and fewer rates — typically
15-25- 35 per cent. Even India legislated comparable rates in 1997. Similarly the corporate income tax rates were slashed — sometimes halved from the prevailing rate — driven by the twin objectives of administrative feasibility
and better tax compliance.
Forces of globalisation also played a major role in the international convergence of tax rates and structures. In a world on increasingly mobile
and frictionless international flow of capital, outward looking national
governments soon realised that getting a share of competitive global capital necessitated keeping the tax rates low and tax rules simple — in line with global trends.
The global experience is with lower tax rates and fewer opaque exemptions, the administration of income tax became much simpler. The administration’s resources was better spent on alternative investments — such as modernising the tax administration through widespread computerisation, including electronic filing, better data processing and mining, and
production of far better statistical output. These resources and inputs, in turn, were more usefully employed both in formulating future tax policy, as well as in better enforcement, through more transparent and finer tax audit selection.
At the beginning of the 21 st century,
some truths about taxation have become self-evident. Even so, they bear repetition.
· First, the design of tax policy is of paramount
importance for tax administration.
· Second, if the objective is to have a
transparent, efficient and feasible tax administration, then the structure of all taxes should comprise common elements. These are low rates, few nominal rates, a broad base, few exemptions, few incentives, few surcharges, few temporary measures. And in the rare instances where there are exceptions, there should be clear guidelines.
The Task Force is unanimously in favour of these overarching fiscal principles. And the recommendations that follow in this chapter and the next derive from these objectives.
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3.2 Personal Income Tax Rates
It is well recognised that the rates of tax affect economic behaviour of taxpayers i.e. choice between work and leisure, the choice between
consumption and savings, and also the compliance behaviour of taxpayeRs.The design of a
personal income tax rate schedule must therefore be equitable and efficient - which are potentially conflicting objectives. A highly progressive tax rate schedule, while meeting the ends of vertical equity, causes higher distortion
in the economic behaviour of tax payers and therefore promotes inefficiency.
Further, high rates of taxes induce tax evasion, thereby undermining the
effective impact on equity. The Report of the Advisory Group on Tax Policy and Tax Administration for the Tenth Plan has enumerated the following principles for designing the rate schedule:
· The basic exemption limit must be at a moderate
level — an appropriate balance between the tax liability at the lowest levels, administrative cost
of collection and compliance burden of the smallest taxpayeRs.The ability of
the tax administration to render quality services to taxpayers will also significantly affect the choice of the exemption limit.
· The number of tax slabs should be few and their
ranges fairly large to minimise distortions arising out of bracket creep.
· The maximum marginal rate of tax should be
moderate, so that the distortions in the economic behaviour of taxpayers and incentive to evade tax payment are minimised.
This Task Force endorses these principles. Personal income tax rates in India were at their peak in 1973-74 — with the exemption limit at Rs.5,000, the minimum marginal rates of tax at 10 per cent, and the maximum marginal rate of tax rising to 85 per cent spread over eleven tax slabs. Additionally, there was also a surcharge of 10 per cent
where the total income was below Rs.15,000, and the rate 15 per cent in other
cases. Therefore the "effective" maximum marginal statutory rate was 97.75 per cent.
The progressivity of the tax system was very high. 8
The large number of tax slabs,also distorted the progressivity
of the tax system due to bracket creep.
The Advisory Group on Tax Policy and
Tax Administration for the Tenth Plan has measured the variation of tax liability for different levels of taxable income and
estimated the coefficient of variation in 1973-74 was then at a high of 1.06. Since then the progressivity
of the tax rate schedule has declined substantially to 0.64.
The
design of the tax rate schedule was neither economically efficient nor
equitable, nor amenable to voluntary compliance. Since those days, there has been a steady increase in the exemption limit,
decrease in the maximum marginal rate of tax, and reduction in the number of tax slabs. As a result, the design of the tax rate schedule has been made relatively more efficient. Since the number of tax slabs has been reduced substantially, the distortion in the equity of the schedule arising due to
bracket creep has also been considerably minimised. However, there has been a steady decline in the progressivity due to the sharp reduction in the maximum
marginal rate of tax and failure to adjust the tax slabs to inflation.
The exemption limit of Rs.5,000 in 1973-74 is equivalent to Rs.50,000 at current prices in 2001-2002. However, the exemption limit was increased to Rs.50,000 in 1998-99 itself i.e. 3 years in advance. Therefore, the increase
in the exemption limit has out paced inflation. Further, a survey of the effective exemption levels across countries indicate that the exemption level in India
is relatively high — thereby keeping out a relatively larger number of people
outside the tax net. If the share of direct taxes to GDP has to be increased to internationally prevalent levels, it is equally necessary that the tax system
is as broad based as in other countries.
At present, there are three tax slabs. Most countries have three to five slabs. As mentioned, greater the number of tax slabs, larger is the
distortion due to bracket creep. The fairest (in terms of horizontal equity in the broadest
sense), the simplest and the most easily administrable form of income tax is a moderately progressive flat, or single marginal rate, income tax levied on a comprehensive base . With a flat rate income tax, most of the defects in, and
the problems caused by, an income tax with a progressive rate schedule virtually disappears 10 .
With a moderate single rate, almost all the deductions and tax-preferences could be eliminated making the task of administration easy. All those with taxable incomes can opt for tax deduction at source to the maximum
extent possible — thus making tax deduction at source can become an important way of collecting tax.
Full integration of personal and corporate income taxes can be achieved by applying the same single rate to both incomes and exempting dividends in
the hands of the shareholders. With a single rate, the inequality in the
treatment between steady and fluctuating incomes as well as between incomes that are concentrated during a short period in life and those that are spread over a
long period will be greatly reduced. All capital gains can be taxed as ordinary
income, with long-term gains being suitably indexed for inflation. With a single
rate, "bunching" does not cause any serious problem.
Government of India,(December 1991),
Interim Report of the Tax Reforms Committee.
10 Ibid.
indexation of the exemption level; there will be no bracket creep. Inflation
will still create problems, but the interaction of inflation and income taxation will
produce
There will be need
only for the
much less iniquitous effects than under a progressive schedule. However, a single rate cannot be pitched at a high level. Therefore, the rate of progression that can be achieved will inevitably be moderate. By
many, this is considered to be the single most significant demerit of the system.
In the Indian context, since a single rate would have to be around 30 per cent, the exemption level would also have to be fairly high. That, in turn, would leave
out some people who could reasonably be brought within the income tax net with a lower tax rate.
The Task Force, therefore, decided to reject the imposition of a single individual income tax rate, and instead opt for a reformed system of personal income tax with more than one rate. The Task Force believes that the
alternative lies in a multiple rate schedule, but with very little spread. An opinion was expressed in some quarters that the entry tax rate in personal income tax should be relatively low so that it does not frighten
potential taxpayers from being in the tax net. However, with a low entry rate, the
number of rates inevitably multiply, and the tax administration ends up at square
one — all the problems associated with a progressive rate schedule.
The Task Force’s aim is precisely to minimise these problems. Our perception is that potential taxpayers at the lower end of the scale are
frightened not by the entry rate of tax (since the average tax continues to be very low)
but more by the compliance and enforcement procedures. The Task Force, therefore, believes that it is not necessary to lower the entry rate of tax.
Further, in view of the distortionary impact of multiple slabs, the Task Force
recommends a two rate schedule for personal income tax. 11
But before outlining the slabs and their rates, it is necessary to explain the empirical reasons for arriving at
such a conclusion.
In 1973-74, the tax rates of 10 per cent and 20 per cent were applicable for incomes up to Rs.10,000 and Rs.20,000 respectively. The corresponding inflation adjusted income levels are Rs.1,00,000 and Rs.2,00,000 in
2001-2002.
Thus, the existing corresponding income levels of Rs.60,000 and Rs.1,50,000 are substantially lower than the inflation-indexed levels — thereby resulting
in an increase in the real tax liability. Historically, while the top marginal
rates of tax have been reduced, the tax liability at the middle has indeed increased. This
has, not surprisingly though, has given rise to the problem of "the missing
middle". If the full effect of the "Laffer Curve" has to be realised, it is not only
necessary to have an optimal enforcement strategy but also ensure that the benefits of a
tax
Committee (Chairman : Professor Raja J. Chelliah).
11 This is consistent with the
recommendations in the Interim Report of The Tax Reforms
cut apply to all class of tax payers — rather than be restricted to a handful
of taxpayers at the top end. This is possibly achieved by broad basing the tax
slabs and we recommend accordingly.
In view of the above, the Task Force recommends
that the personal income tax rate schedule be revised along the lines indicated in Table 1.
Table 1 : Proposed Personal Income Tax Structure.
Income level Tax rates
Below 1,00,000 NIL
1,00,000 – 4,00,000 20 per cent of the Income in excess of
Rs.1,00,000/-Above
4,00,000 Rs.60,000/- plus 30 per cent of the Income in
excess of Rs.4,00,000/-Further,
the revenue gain from levy of surcharge is generally illusory since
such a levy has the effect of increasing the marginal rate of tax, which
adversely
affect compliance.
Therefore, the Task Force recommends that the
present surcharge of 5 per cent on taxpayers with incomes above Rs.60,000/- must be eliminated. in
compliance due to the change / simplification in the tax
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structure.
3.3 Personal Income Tax Base
A negative effect of the early high marginal tax rates was that the income tax became replete with exemptions, allowances, deductions and incentives. Various exemptions and deductions still continue — in spite of significant reduction in personal income tax rates. As a result, the personal income tax
law remains riddled with complexity, which inhibits voluntary compliance.
Further, these benefit only a class of privileged taxpayers
12 and to the extent base
is eroded, the large mass of general taxpayers have to bear the entire burden of
a target revenue mobilisation effort. The consequential effect is the increase
in marginal rates of tax — which in turn distorts economic efficiency and incentivises tax evasion. The very objective of reduction in tax rates is,
therefore, only partially achieved. If compliance is to be fostered and nurtured and
This is further restricted due to
information asymmetry.
economic incentive sustained, it is necessary to review the various
exemptions, deductions and rebates.
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3.4 Exemption Based on Residential Status
Under the Income Tax Law in India, the tax base of a taxpayer is effected by the residential status enjoyed by him. A taxpayer could have one of the following three residential status:-
·
Resident : A taxpayer is treated as a resident if he is:
(a) Resident in India for 182 days or more during the financial year;
(b) In India for a period of 60 days or more during the financial year and resident in India for at least 365 days in aggregate during the preceding four financial years.
· Resident but Not Ordinarily Resident : A
taxpayer is treated as resident but nor ordinarily resident if he is:
(a) Resident in India for less then 9 years out of the preceding 10 financial years ; or
(b) Resident in India for a period or periods amounting in all to less then
730 days during the preceding 7 financial years.
· Non Resident : A taxpayer is treated as
non resident if he is neither a resident or resident but not ordinarily resident.
Residents are subject to tax on their worldwide income. Persons who are resident but not ordinarily resident are taxed only on Indian-sourced income
13 , Non-residents are taxed only on Indian-sourced income and on income received, accruing or arising in India.
Persons who are resident but not ordinarily resident, enjoy exemption in respect of their foreign sourced income, even though in qualitative terms
they are no different from residents. To the extent that most double taxation
avoidance agreements provide for taxation of interest income in the country of
residence, persons who are residents but not ordinarily residents enjoy exemption from foreign tax by claiming to be residents in India for the purpose of a treaty.
Thanks to this peculiar category, therefore, a large number of such taxpayers end up paying no tax on their foreign sourced income, either in India or in any
other part of the world. Further, most countries across the world provide for only two
status: Residents and Non-Residents.
This includes income deemed to accrue
or arise in India, income received in India or income received out-side India arising from either a business controlled, or a
profession established, in India.
Nonresidents may also be taxed on
income deemed to accrue or arise in India through a business connection, through or from any asset or source of income in India,
or through the transfer of a capital asset situated in India (including a share in a company
incorporated in India).
Accordingly, the Task Force recommends that residents but not ordinarily residents must be subjected to tax on their global / worldwide income at par with residents. To do so, this unusual category of resident but not ordinarily resident taxpayers must be deleted.
This will not only enhance the income tax base, but also remove an antiquated anomaly and simplify the law.
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3.5. Standard Deduction for Employees
Under the Income Tax Act, a taxpayer is allowed a deduction of a certain percentage of his salary income subject to a maximum amount as standard deduction in the computation of his salary income chargeable to income tax.
At present standard deduction is allowed from the gross salary of the tax payer, according to the following schedule :-1.
For gross salary below Rs.1.5 Lakh the amount is restricted to 1/3
rd of the gross salary or Rs.30,000, whichever is less.
2. For gross salary between Rs.1.5 Lakh and Rs.3 Lakh, the amount is
restricted to Rs.25,000.
3. For gross salary between Rs.3 Lakh and Rs.5 Lakh, the amount is restricted
to Rs.20,000.
4. For gross salary above Rs.5 Lakh, no standard deduction is allowed. In addition to the above, salaried employees are also eligible for a deduction up-to a maximum of Rs.9,600 towards conveyance allowance received from their employer. This deduction is allowed ostensibly to compensate on an estimated basis for the expenditure incidental to the employment of the
taxpayer.
The levels of standard deduction have increased substantially over the years both in terms of the percentage and the overall ceiling — almost out of sync with the actual employment related expenses. The level of Rs.500 in
1974- 75 allowable as standard deduction would now be equivalent to approximately Rs.5,000 in current terms. Once conveyance expenditure is separately exempted from taxation, it is difficult to visualise any other employment related
expenditure other than personal in nature. This is particularly so when most employers provide for books and periodicals in the work place
15 .
In fact in the government, the
expenditure by senior officers on newspapers is reimbursed. In the case of the corporate sector, the expenditure on newspapers and
periodicals is an allowable business deduction without being treated as a perquisite in the hands of the
employee.
Unfortunately over the years, the increase in the standard deduction is an outcome of periodic demand for increase in the exemption limit by the
salaried employees. Further the provision of a standard deduction to salaried
taxpayers over and above the basic exemption limit is iniquitous in as much as it discrimates against self-employment. The Advisory Group on Tax Policy and Tax
Administration for the Tenth Plan strongly recommended downward adjustment of this benefit. Since then, the Task Force has also collected information
across countries on the allowability of employment related expenses.
The loss in revenue on account of standard deduction is quite vast — the more so because conveyance allowance is exempt from tax. Also, standard deductions of this relative scale are not in line with the best international
practice and our recommendation on enhancing the general exemption limit.
The Task Force, therefore, recommends that standard deduction under Section 16(1) of the Income Tax Act should be eliminated
16 . The additional liability of a taxpayer on this account will be more than met by the reduction in rates of personal income tax proposed by the Task Force.
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3.6. Treatment of Imputed Income from Owner Occupied House Property
Up to assessment year 1986-87, a notional annual value subject to a maximum of 10 per cent of the adjusted total income was imputed to the
benefit flowing from the self occupation of the house property. Accordingly full allowance by way of deduction was made for ground rent, repair and maintenance, interest on borrowed capital and similar other items of
expenditure.
However, from assessment year 1987-88, the notional annual value imputed to the benefit flowing from self-occupation of the house property was deemed to be nil. Accordingly, it was provided that no deduction for the
various items of expenditure would be allowed except a small amount of Rs.5,000 towards interest on borrowed capital. While non-deductibility of the various
items of expenditure is consistent with the matching principle that expenditure
relating to a particular item/source of income should be allowed only if the income is liable to tax in the economic /accounting sense, the allowability of interest expenditure up-to Rs.5,000/- is a deviation from this principle. This is,
therefore, in the nature of a tax subsidy. Such a tax subsidy is both iniquitous and inefficient.
These problems have been further compounded by increasing the ceiling from Rs.5,000 to 1,00,000 in assessment year 2001-02, and further to
Rs.1,50,000 for assessment year 2002-03 and subsequent years. The increase far exceeds the inflation during this period. Moreover, the annual interest
out-go
16 The continuation of the present
exemption of Rs. 9,600/- in respect of conveyance allowance received by an employee should serve as a reasonable deduction for employment
related expenses.
of Rs.1,50,000 implies an EMI payment of approximately Rs.35,000 per month. A tax subsidy for such high levels of EMI payment only helps to undermine
vertical equity. In fact in most countries, the mortgage interest in respect of loans
for acquiring owner occupied dwelling is not deductible, as Table 2 shows.
Table 2: Tax Treatment of Mortgage Interest for Owner Occupied Dwelling
Country Is Mortgage Interest Deductible for Tax Purposes?
Canada No
France No
Germany No
Italy Yes, A credit up to 19% of the interest paid, up to a maximum
credit Italian 392.51 is granted to the loan drawn up before
the year 1993. However, imputed income from owner
occupied dwelling is also subjected to tax.
Japan Yes, subject to limit of Yen 5,00,000/-.
Netherlands Yes However, imputed income from owner occupied dwelling
is also subjected to tax.
Sweden Yes
United Kingdom No
United States Yes, subject to limits
Thailand Yes, up-to maximum of 50,000/- Baht
New Zealand No
Malaysia No
Indonesia No
Philippines No
Argentina Yes, up to a maximum of ARS 20,000/- annually.
Peru No
Australia No
India Yes, up to a maximum of Rs.1,50,000/ -In view of the fact that interest rates for housing loans are sharply reducing, and that the average home loan is around Rs.5 lakh, the Task Force recommends the phasing out of the deduction for mortgage interest in respect of loans for acquiring a owner occupied dwelling. The deduction should be reduced to Rs.1,00,000/- in assessment year 2004-05, to Rs.50,000/- in assessment year 2005-06 and NIL in assessment year 2006-07. This proposal will help rationalize the tax base.
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3.7 Tax Treatment of Agricultural Income
The continued exemption of agricultural income from the scope of income tax continues to be a sore point with all taxpayers. For the sake of brevity,
this Task Force does not consider it necessary to repeat / reproduce the various arguments advanced by experts. Briefly, the arguments in support of an income tax on agriculture are the following:
1. It distorts both horizontal and vertical equity ;
2. It encourages laundering of non-agricultural income as agricultural income
i.e. it has become a conduit for tax evasion.
Both the arguments are empirically verifiable. A close look at the tax
returns of a large number of taxpayers in Mumbai by the Task Force revealed the following:
· A number of taxpayers had claimed large amount of
income from agricultural operations. Since such income enjoyed exemption from the central income tax and there was no such tax effectively in place in the States, such taxpayers enjoyed favorable treatment visa viz. those earning equivalent level of
income from non-agricultural activities. To this extent horizontal equity was
distorted.
Similarly, the favorable treatment of agricultural income also adversely
affected vertical equity.
· Prima facie the claims for income from
agricultural operations appeared to be doubtful to most officers since the agricultural operations are claimed to
have been carried out in areas which are known to be infertile. Large-scale investigations against such claims are under progress. The department is expecting that most of these claims are likely to be withdrawn by the
taxpayers.
Based on the sample in Mumbai, the revenue loss from laundering of
non-agricultural income as agricultural income is estimated to be Rs.1,000 crores.
Given the distortionary impact of continued exemption of agricultural income
and the tax assignment under the Constitution, the
Task Force recommends the following :-
(a) A tax rental arrangement should be designed whereby States should pass a resolution under Article 252 of the Constitution authorising the Central Government to impose income tax on agricultural income. The taxes collected by the center would however be assigned to the States.
(b) Tax from agricultural income for the purposes of allocation between
states will be the difference between the tax on total income (including agricultural income) and the tax on total income net of agricultural income.
(c) Where a taxpayer derives agricultural income from different states, the revenues attributable to a state will be in the ratio of the income derived from a particular state to the total agricultural income.
(d) A separate tax return form should be
prescribed for taxpayers deriving income from agriculture.
These recommendations will help mobilise additional resources for the States without the attendant problem of administering the agricultural income tax. Further, given our recommendations on increasing the exemption limit to Rs.1,00,000 per individual, most agricultural farmers would continue to remain out of the tax net. The proposed rental arrangement with the states could be packaged with the rental arrangement for taxation of services.
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3.8 Rationalizing income tax exemptions on savings instruments Tax exemptions for savings instruments have earlier been extensively analyzed by various committees and expert groups in the course of their deliberations relating to other fiscal and financial issues. The most comprehensive of these reports have been those of the Committees chaired by Dr. Raja J Chelliah, Dr. Parthasarathi Shome and Dr. Y.V. Reddy 18 . Given their sensible and comprehensive treatment of tax exemptions relating to savings,
this Committee is of the view that the best way to proceed is a judicious adoption
of the best recommendations culled from these Reports, with only some slight modifications designed to enhance consistency and ease of implementation, rather than an elaborate "re-invention of the wheel", as it were.
Consumption expenditure rather than income serves as the most efficient form of tax base under an ideal tax system. Inspite of this, no country in
the world has been able to successfully implement expenditure tax due to serious administrative problems. Almost all countries have relied upon income as a
tax base. However a tax on income is inherently biased against savings. There are two alternative ways of devising an income tax which neutralises this bias
and therefore effectively uses consumption as a tax base :-(
a) Exempt Exempt Taxed (EET) Method : Under this method, the contributions to a saving plan / scheme are deductible from the gross income, the income (accumulations) of the plan / scheme is exempt from tax and the withdrawal of the contribution along with benefits in the form of interest, dividend etc.
is subjected to tax.
(b) Taxed Exempt Exempt (TEE) Method : Under this method, the contribution to a saving plan /scheme are out of post tax income (i.e. contributions are
taxable), the income accumulation is exempt from tax and the withdrawal of the contribution along with benefits in the form of interest, dividend etc. is
exempt from tax.
In order to neutralise the bias against savings, most countries design their income tax structure, so as to provide for exemption / concessional tax
treatment of the various savings instruments by following one of the two methods . Some experts are also of the view that the distortion arising out of the inherent
bias against savings could be tolerated by adopting a simple income tax structure
with Advisory Group on Tax Policy and Tax
Administration for the Tenth Plan, Planning Commission, May 2001.
Expert Committee to Review the System
of Administered Interest Rates and Other Related Issues, September 2001.
19 The psychological impact of EET,
however, providing tax benefits at the contribution stage, would be greater in promoting financial accumulation (Reddy Committee, 2001). It may be noted that approximately two thirds of OECD countries follow the EET system, with
some variations, for taxation of savings.
reasonable rates and a comprehensive base. The theory of tax incidence on financial instruments indicates no reasons for differential treatment for those of long-term maturity from those of
short and medium-term maturity, taking the view that the term structure of interest
rates would ensure efficient allocation of savings. In particular, the demands of
fiscal neutrality that imposition of tax should not distort the choice between (a)
different forms of saving, and (b) between consumption and saving are ensured under a non-discriminating tax treatment of savings irrespective of the maturity
period. No strong empirical evidence exists, moreover, to support a hypothesis that tax incentives facilitate increased financial savings (by the private sector) at
a macro level . There
is, therefore, a strong justification for taking an integrated view of fiscal concessions for financial instruments of all maturities.
Report of the Expert Group to Review
Existing Fiscal Incentives for Savings (Chairman: P. Shome), May 1997.
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3.9 Tax Treatment of Savings in Select Countries
In the USA, a section 401(k) plan is a type of deferred compensation plan in
which an employee can elect to have his employer contribute a portion of his wages to
the plan on a pre–tax basis 1
. These deferred wages are not included in the taxable wages
but they are subject to social security, Medicare, and federal unemployment
taxes. The amount that an employee may elect to defer to a 401(k) plan is limited.
During 2001, an employee cannot elect to defer more than $10,500 for all 401(k) plans in
which the employee participates. But if the employee participates in a SIMPLE 401(k)
plan 1 , the limit for 2001 is $6,500. Both of these limits are indexed for inflation.
Generally, all deferred compensation plans in which the employee participates must be
considered to determine if the $10,500 limit is exceeded. All contributions to retirement
plans (including deferred compensation plans) are subject to additional limits.
Housing, pensions and Individual Savings Accounts (ISAs) now cover the saving activity of the bulk of the population in the UK. Over the last two decades
the UK has moved from an incoherent tax regime for savings to a seemingly more
satisfactory one
21 . The
four main schemes designed to encourage savings, keeping in mind an aging population, had been the Business Expansion Scheme (BES), Private
Personal Pensions (PPP), Personal Equity Plans (PEP) and Tax Exempt Special Savings Accounts (TESSA)22
. Personal Equity Plans were announced in the 1986 Budget, implemented in 1987 but substantially reformed in later years.TESSA was
announced in the budget of March 1990 and became available from January 1991. PEPs were a vehicle for investment in equities, with tax-free income. Contributions to
PEPs were not tax deductible, but any income or capital gains accrued within a PEP are tax
free, and there is no tax on withdrawals. TESSAs gave the same tax treatment as a PEP
for funds in designated schemes with annual contribution limits; saving were out
of taxed income but interest earned is tax free and there is no tax on withdrawals.
This led to a situation of disparate tax treatment of different instruments used for
similar purposes as well as for short- and long-term savings instruments. For example, for
housing, equities and cash saving, saving was out of taxed income and there was no tax on
returns and no tax on withdrawals, while, for pensions, saving is out of untaxed income,
their fund income is untaxed but withdrawals are taxed. These two regimes produced the
same effective tax rate of zero on the real return to saving. The one obvious
exception is the existence of the tax-free lump sum in pensions, which makes the effective tax
rate on the return to pensions saving negative.
In a bid to encourage personal saving, reforms introduced in November 2001 in Chile 23 allow
new tax incentives to both salaried workers and the self-employed to
21 Individual Savings Accounts (ISAs)
have superseded PEP and TESSA (see text) since April 2001. ISAs are similar to the older schemes in most important respects and
are designed to integrate the tax treatments for savings of disparate schemes. Existing
subscribers to PEPs and TESSAs can continue with the schemes or migrate to ISAs.
22 The Institute for Fiscal Studies, UK,
Briefing Note No. 9, "A Survey of the UK Tax System", November 2001.
23 "Capital Markets in Chile", Investment
Review, Foreign Investment Committee, Chile, February 2002.
encourage voluntary contributions to private pension funds. These will allow
voluntary contributions to be deducted from an individual's taxable income. In order to
qualify as deductible, they must, however, be invested in certain assets, such as mutual
and other investment funds and life insurance, duly authorized by the appropriate
regulatory authority. In addition, the new regulations allow individuals to withdraw
part or all of their voluntary pension savings before reaching retirement age. However, in order
to guard against excessive use of this prerogative, an exit tax will be levied on
withdrawals, which will be treated as taxable income. Before the reform, only the AFPs
(pension fund administrators) were allowed to offer tax-deductible savings schemes.
The Supplemental Retirement Scheme (SRS) 24
in Singapore, effective April 2001, is designed to encourage working employees to save for retirement, over
and above their contributions to the Central Provident Fund (CPF). Contributions
to the SRS by residents (up to an overall limit of S$15,000) are tax deductible the
following year.
The savings corpus, including interest, are to be taxed only upon withdrawal.
Claims for deductions from taxable income are made automatically by the SRS operator to
an individual’s taxable income the following year. A penalty of 5 percent is
imposed on premature withdrawal before retirement. The taxable base of the SRS corpus
for an
individual is 50 percent of his corpus, at a tax rate based on the
individual’s graduated tax rate of 0-26 percent.
The Indian tax system (emanating from the Income Tax Act, 1961) provides broadly the following types of tax incentives for financial savings:
(a) Deductions, provided in Section 80L allow for exemption of income up to Rs.12,000/- from income tax on specified financial instruments (including
bank deposits, NSC, post office deposits, Government securities, etc. with an additional and exclusive sub-ceiling of Rs.3,000 for interest income arising
from Government securities).
(b) Exemption under Section 10(10D) in respect any sum received under a life insurance policy, including the sum allocated by way of bonus on such policy [other than any sum received under sub-section (3) of section 80DDA] [or
under a Keyman insurance policy]
(c) Unlimited exemption under Section 10(11) and Section 10(12) in respect of
any payment from a provident fund set up by the Central Government or set up
under the Provident Fund Act 1925 or a recognised provident fund.
(d) Unlimited exemption under Section 10(13) in respect of any payment from a Superannuation Fund.
(e) Unlimited exemption under Section 10(15)(i) in respect of income by way
of interest, premium on redemption or other payment on notified securities,
bonds, annuity certificates, savings certificates, other certificates and deposits
issued by the Central Government.
24 Internal Revenue Authority of
Singapore, SRS Brochure, 2001.
(f) Unlimited exemption under Section 10(15)(iib) in respect of interest on
notified Capital Investment Bonds. However, no bonds can be notified after first day
of June 2002.
(g) Unlimited exemption under Section 10(15)(iic) in respect of interest on
Relief Bonds.
(h) Unlimited exemption under Section 10(15)(iid) in respect of interest on
notified Bonds. However, no bonds can be notified after first day of June 2002.
(i) Unlimited exemption under Section 10(15)(iv)(h) in respect of interest on
notified public sector bonds.
(j) Unlimited exemption under Section 10(15)(iv)(i) in respect of interest on
deposits out of moneys received by an employee on retirement.
(k) Tax rebate, provided in Section 88, in respect of investment in specified
assets (such as NSC, NSS, EPF and PPF, tax saving units of mutual funds, premium paid on life insurance, repayment of housing loans, and infrastructure bonds
of IDBI and ICICI). In the financial year 2002-03, the rebates are provided at
the following rates:
(i) The rebate shall not be available in case of persons having gross total income (before deduction under Chapter –VIA) more than Rs.5 lakhs.
(ii) For persons having gross total income (before deduction under Chapter – VIA) above Rs.1,50,000 but not more than Rs.5 lakhs, the rate of rebate shall be 15%
(iii) The rebate 20% shall continue for tax payers having gross total income, (before deduction under Chapter – VIA) not exceeding Rs.1,50,000.
(iv) The rebate shall be higher @ 30% for salaried tax payers having gross salary income not exceeding Rs.1 lakh (before allowing deduction under Section 16) and where gross salary income is not less than 90% of the gross total income from all other sources.
The limit of qualifying investment is Rs.1 lakh with exclusive limit of Rs.30,000 for subscription to equity shares or debentures of infrastructure companies, public financial institution and mutual funds.
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