Sunday, January 13, 2013

Higher taxes on the rich….another blunder waiting to happen

We have the penchant for making economic blunders. We do it all the time. We have this unique inability to take tough, rational decisions and prefer taking soft, irrational ones instead. By subsidizing diesel prices and increasing petrol prices, we have created an artificial gap between the two equal fuels, and created a bizarre situation where urban car buyers are buying diesel cars for all the wrong reasons. We have also managed to do the same thing with our Railways. We have kept increasing freight charges because that is politically easy to do, but we haven’t increased passenger fares for nearly a decade. As a result, freight rates are so high that the business has become uncompetitive v/s road transport, and still the Railways suffers from low revenues.

We are all set to make the same mistake with our income tax policy now. There is a buzz that some influential sections of the bureaucracy – including the Chairman of the PM’s Economic Advisory Council C Rangarajan – are in favor of increasing the tax rates in the highest slab (above Rs 8 lacs annual salary). The proposal is bizarre – to increase highest rates to 40% from the present 30%. Add surcharge, and effective tax rates would climb to 44% from the present 33%. Of course, there are some tax benefits available to tax payers, but even so, the highest tax rate will come to more than 35-38% depending on the exact income of the person and exact benefits availed.

This is no doubt inspired by a similar move the US has recently taken – increasing the highest tax slab to some 39.6% from the erstwhile 35% (add up to 15% for state taxes taking the total to 54.6% now). Indians are very good at aping the West, and this move of Indian bureaucrats to ape the US is no different. What is being lost in the process is objectivity, and rational thinking, for the case of the US is totally different from that of India.

For one, the US is in a different league of countries that it competes with. The US is essentially a knowledge economy – it’s a world leader in technology, telecommunications, defence, basic sciences and engineering. Its peers are largely countries of Western Europe and Japan and a few others. When the US increases tax rates, it has to keep in mind comparable taxes in these countries. And the tax rates in these countries are far higher than they are in the US (Europe in particular has rates higher than 50% in the highest slabs; in France it is a crazy 70%). So if flight of capital and entrepreneurs takes place at all, it is unlikely to be very significant since the options are hardly attractive. Businesses and entrepreneurs are likely to complain, but they will stay put. At best, the low end businesses manufacturing driven businesses may migrate to Asia where tax rates are lower. In other words, the US can perhaps absorb the higher tax rates.

The same is not true for India. The comparable set of countries for India are China and those in SE Asia. In all of these countries, the tax rates are lower than those prevailing in India. The top rate in our South East Asian competitors like Singapore is 20%, Malaysia 26%, Indonesia 30% and Phillipines 32%. Our neighbors have low tax rates as well: Sri Lanka and Pakistan 35%, Nepal and Bangladesh 25%. In comparable BRIC nations, the highest tax rate in Brazil is 27.5% and in Russia it is 13%. Only in China is the highest rate higher at 40%, but then China is a different ball game entirely… country in the world can compare itself or model itself on China. If India were to increase tax rates, it will take only a few moments for capital and entrepreneurs to migrate abroad. Already, thanks to the rampant bureaucracy in India, the shortage of electricity, the land acquisition problems and the general harassment meted out to business folks, big industry is talking of moving out of India. Increase rates, and the exodus will begin in right earnest.

We must remember that India is essentially a low-end economy. Our biggest success has been the BPO sector – which is nothing but a play of labor arbitrage. Our second biggest success has been in IT services, but again, we are competing largely on the back of lower rates. We still don’t have any branded IT products, for which we can command price premiums. All our work is “contractual” by nature and the IP continues to be owned by US and European clients, not by our IT companies. Likewise, in manufacturing, a bulk of the product technologies and brands belong to foreigners. We are merely a manufacturing base. We are hardly in a position to put stiff terms on MNCs to set shop here.

The only redeeming factor for India is the vast domestic market that we offer to foreign products. This market is extremely attractive to Indian and foreign businesses. This is why we have continued to grow inspite of all the problems mentioned above, and in spite of the already high taxation rates. Increase the rates and that may be the proverbial last straw on the camel’s back. Foreigners would rather manufacture abroad and export the goods into India, what with customs duties far more favorable today.

So the case of the US is totally different from the case of India. We must also not forget that there is rampant corruption in India. The way to increasing tax collection in India is to reduce tax rates, so that people feel like paying up. If tax rates go up, to the levels that existed before Chidambaram rationalized them a decade back, there will be again be rampant evasion of taxes. Corruption in the IT department will increase exponentially. It will mean a reversal of all the smart IT laws India has followed in the last decade. It simply doesn’t make any sense at all.

I hope good sense prevails. This government is known to make blunders….and after taking those flawed decisions, it reverses them. We saw this happen with retrospective taxes where everyone is scurrying around to allay fears of aggressive tax action. The same also happened with GARR with Chidambaram undoing the mess that Pranab Mukherjee left behind.

The real truth is that we need lower taxes, not higher. Besides, we don’t need higher tax rates to increase our tax collections. We need better compliance. We need to tax everyone evenly. The rich amongst the farmers must be brought into the tax net – so many of the wealthy people are abusing this provision. Rather than creating arbitrary and unsustainable quirks in the tax system, it is important that we make the system simple. Increasing taxation arbitrarily for the rich may be politically expedient, but will damage Indian economy enormously….

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