Wednesday, July 28, 2004

Kelkar Committee Task Force Report

The report of the Task force on FRBM Act 2003 was made public last week. The report discusses the Fiscal challenges and the role of Tax reforms in meeting the Challenges. The latter cover Customs, CENVAT and Income tax and are modified versions of those given in the Kelkar Tax Reform Reports (December 2002). As there is now a large measure of unanimity among tax experts on the broad thrust of tax reform, the article focus on proposals that I disagree with.
Let us start with the proposal to convert the CENVAT into a comprehensive VAT. We have argued in several notes and papers since 1998 that the CENVAT should become a full fledged VAT covering all services and goods except those explicitly excluded for efficiency or equity reasons (e.g. Indian Express of July 6, 2004). The new report makes two interesting points: One that the Constitution 88th amendment act (2003) makes it possible to extend the CENVAT up to the retail level. Two that the revenue neutral basic rate of the CENVAT including both goods and services is around 12%. The discussion of how the CENVAT should replace the stamp duty and other imposts on real estate and of how to apply the CENVAT to the financial sector is quite illuminating.
The report also recommends 3 rates (0, 6% and 20%) in addition to the Standard rate of 12%. The negative list of exempted goods (0% rate) is what I have proposed earlier with one important item missing, namely processed food. There is a strong case for including all processed food in the 0% category instead of in a 6% category, because greater employment in agriculture and agro-processing and reduced wastage of agricultural produce would be added benefits. This serves the purpose of equity much better than a separate 6% category with a number of ‘necessities.’ I am also against a separate 20% CENVAT rate for luxury goods: Polyester is the poor man’s fibre not a luxury and it is absurd to classify carbonated drinks as a luxury item in this day and age. Cars, polluting fuels (petrol, diesel) and tobacco (de merit good) should however be subject to an additional special excise/sales tax rate (8%) that cannot be set-off. The recommendations on the treatment of small units are sound (exemption up to Rs. 25 Lac) and pragmatic (choice of 4% sales tax rate up to 1 crore). Monitoring will be much easier in the system proposed by us.
The report also estimates that a revenue neutral standard rate for a State Vat (what I have termed STATVAT) covering goods & services is 8% and proposes three other rates (0%, 4%, 14%) at the State level. It rightly notes that such a state VAT should replace all other taxes on goods and services at the State level. In my view there is no need for a 4% rate and the list of exempted items can be the same as for the CENVAT. Similarly instead of another 14% rate category, a sales tax of 6% could be applied at the retail level on hotels, restaurants, entertainment and betting/gambling, in addition to the standard STATVAT rate.
The Task force proposes a 5%, 8%, 10%, 20% customs duty/tariff rate structure. As acknowledged in the first Kelkar report, the Virmani Committee report of the Department of Revenue (2001) had demonstrated, (a) the negative effect of such a 4-tier structure in terms of effective protection and (b) the advantages of a single uniform rate of 10%. In fact we are now confident, based on a recent ICRIER research paper showing the positive effect on exports and productivity, that tariff rates can be reduced further to a uniform 5% in the next 5 years. Both the Virmani (2001) and Kelkar (2002 & 2004) reports concur that agriculture tariffs have to be dealt with more cautiously. The former however proposed that these tariffs should not be more than 2 or 3 times the standard peak rate (i.e. 20/30% & 10/15%) while the latter recommends an exorbitant rate of 150%.
Turning finally to income tax, the very sound arguments for low marginal tax rates and elimination of exemptions (ineffective & inefficient) are repeated in this report. I do not however agree with the proposal to move to a two rate (20%, 30%) system. The reason why experts have recommended a flat (single rate) income tax is that such a tax would have the lower marginal rate (e.g. Chintan #2, May 1997) than a 2 or 3 rate system. If the 2-rate system is going to have the same marginal rate of 30% as a 3-rate system there is no benefit from the former. On the other hand a gradually rising marginal tax rate of the latter results in a more efficient (lower average marginal rate) system that provides less dis-incentives for honest declaration to both first time tax payers and the ‘missing middle’. Further India has a much higher exemption limit (in PPP terms) then other Asian systems but its tax rapidly exceeds all others. I would therefore recommend the following structure 10% above Rs 60000, 20% above 1.2 (/1.32/1.44) lac and 30% above 3.96 (or 4.2) lacs.
The proposal to eliminate savings exemptions and replace it with an Individual Saving Account is a sound one. However, the EET system proposed for pension savings etc. along with grand-fathering is too complicated. The report has an interesting calculation of the economic depreciation rate, which is calculated as 15%. This needs to be cross-checked. Though the personal and corporate income tax recommendations are consistent, the MAT should be abolished along with exemptions and depreciation rate reduction. Further, in my judgement a system of corporate tax (CIT) credit to all shareholders for CIT paid by the company is preferable to abolition of the income tax on dividends and capital gains on equity. This can be implemented very easily in the proposed Tax Information System. Space limitations do not allow a more detailed analysis.

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