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Piecemeal tax reform seen in national budget

With economic growth slowing, inflation rising and direct foreign investment reduced to a dribble, India is under tremendous pressure to make itself a more appealing place to invest.

Yet the government budget to be unveiled on February 28 for the year beginning in April is likely to take a piecemeal approach to tax reform, an area with vast potential for influencing investment behavior, analysts say.

In a speech last Wednesday to the Associated Chambers of Commerce and Industry (ASSOCHAM), Finance Minister Yashwant Sinha said tax rationalisation was the single most important aspect of the economic reform process.

Ultimately, analysts say, India should replace its crazy-quilt system of excise taxes, tariffs and tax holidays - the decrepit heritage of years of pandering to special interests and a desire to shield domestic industry - by adopting a simplified value-added tax system.

"Salvation for all lies in a unbroken regime of a 16 per cent value-added tax," the finance minister told the ASSOCHAM gathering.

But he indicated no leap in that direction will be made in the upcoming budget.

Instead it will continue the thrust of past budgets in lowering customs duties to bring them in line with Asian tariff levels but leave corporate and individual income taxes unchanged.

Corporate and personal income tax were projected to generate about a third of all government revenue in this year's budget.

"My predecessor has cleared up the direct tax rates, and except for surcharge rates I have not interfered because I find it reasonable when compared to other nations," Sinha told the ASSOCHAM.

A new two per cent income tax surcharge imposed to raise money to rebuild areas devastated by last month's earthquake has boosted the top corporate tax rate to 39.55 per cent.

The top individual tax rate - on income above Rs 150,000 ($3,224) - has risen to 35.1 per cent.

CUSTOMS DUTIES, EXCISE TAXES

The budget is however expected to outline important changes in customs duties and excise taxes. That's because under World Trade Organisation (WTO) rules, India must scrap quantitative restrictions (QRs) on imports as of April 1, and the Finance Ministry will cut or scrap import tariffs on 714 items.

That will greatly affect government finances as customs duties now account for about a quarter of government revenue, and excise taxes another third.

With the government's fiscal deficit already pushing 5.1 of gross domestic product (GDP) for the current year, New Delhi also needs to come up with another Rs 157 billion to fund quake reconstruction if it's to prevent India's crushing public debt of $340 billion from expanding.

Simply paying the interest owed yearly on that debt consumes 30 per cent of government receipts; two-thirds of government spending goes toward paying interest and principle.

But tax experts say that raising taxes will not necessarily increase government funds and may even have the opposite effect by encouraging people to find new ways of avoiding them.

"Experience has shown that increasing tax rates does not boost govt revenue," said N V Iyer, a chartered accountant at Deloitte Haskins Sells.

Raising taxes now could also further slow economic growth, forecast at 6.0 per cent for the current year to March.

That is down from an annual average of over 7.5 per cent for three straight years in the mid-1990s and well below the 10 per cent that economists say is required to meet the needs of a growing population, which already tops one billion.

SERVICE TAX

It's possible, though, to increase revenues without raising tax rates by widening the tax base and overhauling the tax system to eliminate concessions and exemptions, says V U Eradi, a former member of the Central Board of Direct Taxes.

The simplest way of widening the tax base is to extend the five percent service tax to cover a greater number of service industries.

Only five per cent of services now are subject to the service tax, even though the sector accounts for more than 50 per cent of the Indian economy.

An advisory committee to the finance minister has recommended the tax be imposed on 20 fast-growing services, including cable operators, cargo services, jewellery and fashion designers, and beauty parlours.

The banking sector, especially consumer banking services, may also be brought under the service tax net. The expert group on service tax identified 27 taxable consumer banking services but excluding primary banking functions such as lending or borrowing.

More controversial are calls to extend the service tax to India's vibrant computer software industry. The National Association of Software and Services Companies (NASSCOM) predicts India will rake in $6.2 billion from software service exports this year, and $9.4 billion next year.

Nasscom chief Dewang Mehta met with the finance minister last Wednesday to lobby against the service tax being extended to the software service industry, saying e-commerce is not taxed anywhere in the world and doing so in India could greatly damage the domestic industry.

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