Direct Tax Code Analysis

The government has released a comprehensive discussion paper and draft of

the new Direct Tax Code that seeks to revamp and simplify the Direct Tax
Law and its administration in the country through several radical changes.
The code, which the government plans to enact and implement FY2012
onwards with suitable changes if required, envisages meaningful reduction in
the tax rates while simultaneously being revenue neutral for the government.
It aims to achieve this by increasing the tax base and rationalising the myriad
tax incentives prevalent under the current law. In our view, the overall
changes proposed will be quite beneficial for a number of sectors and
companies, albeit definitively withdrawing tax holidays being currently
enjoyed by different sectors, something that has been contemplated and
proposed often in the past and therefore should not come as a major
negative surprise.

Reduction in effective tax rates for Individuals a positive

The Tax code proposes a significant increase in the tax slabs for personal
income tax which, if implemented, will result in a meaningful increase in
disposable income, especially benefiting FMCG and other domestic
consumption stories. At the same time, the code proposes to do away with
the distinction between long and short-term capital gains and abolish the
Securities Transaction Tax (STT), effectively taxing all capital gains at the
applicable marginal tax rate for the tax-payers’ total income. At present, the
long-term capital gains tax is Nil on equity transactions on which STT is paid
and 20% on all other assets, while the short-term capital gains tax rate is
10% on equity transactions on which STT is paid and 30% on other assets. In
our view, the proposed increase in tax slabs is quite substantial in view of the
country’s per capita income distribution, and should reduce the impact of the
proposed increase in capital gains tax rates.

Tax incentives on Savings

The code also proposes to increase the tax deduction limit available on
savings from Rs1lakh at present to Rs3lakh. However, the tax incentives on
Interest paid on home loans is proposed to be withdrawn. On a further
negative note, the code also proposes to tax the savings in various
instruments including PPF, Insurance, etc. at the time of withdrawal, i.e.
investments in tax savings instruments will only lead to a postponement of
tax liability rather than an outright exemption as applicable at present.
Moreover, retirement benefits such as gratuity will be tax-free only if
deposited in specified retirement benefit schemes.

Effect on Corporate.
The Direct Tax Code proposes a substantial reduction in the rates of tax on
corporate income, near-removal of the difference in the tax treatment of
domestic and foreign companies and a shift in the base of minimum alternate
tax (MAT) from book profits to value of gross assets. It also envisages doing
away with a large number of exemptions and deductions though in a few
cases, these profit-linked incentives are replaced with a new set of incentives
linked to capital investment.

The net impact of these measures on India Inc would be substantial and
mostly positive but might vary from company to company, say tax experts.
There could be cases where the removal of incentives coupled with the new
methods computation would expand the tax base by up to 40%, netting out
the benefit of the low tax rate.

Once the code is implemented, both domestic and foreign companies would
be paying tax at a low rate of 25% as against 33.99% and 42.23%,
respectively, at present (inclusive of surcharge and education cess). While
domestic companies would pay a 15% tax on the dividends that they actually
distribute, foreign companies would be required to pay a ‘branch profit tax’ at
the same rate whether or not they remit profits outside the country.
The code proposes to treat capital gains as business income. Losses
would be allowed to be carried forward indefinitely. As expected, the new tax
code does not provide for area-based exemptions, which anyway have end
dates prescribed.
On double taxation avoidance, the code says neither the relevant
bilateral treaty nor the code would have a preferential status and in the case
of a conflict, the one that is later in point of time would prevail.
As per the code, MAT would be 0.25% of value of gross assets in case
of banking companies and 2% of that value for other companies. The authors
of the code justify the re-definition of MAT as an ‘assets tax’ saying that this
would allow companies to expect to earn a specified average rate of return
on their assets which is an “incentive for efficiency”.

However, under the proposed dispensation, even loss-making companies

could end up paying MAT. Also, companies making huge investments would
gain from the 100% write-off of capital expenditure in the first year itself, but
this gain would be partly negated as they would pay MAT on the value of
assets created. Infrastructure companies that have to wait for long years
before starting to make handsome profits would have to pay MAT even in the
initial years of low/nil profitability.
And since MAT would be treated as a ‘final tax’, it won’t be possible to carry it
forward for claiming credit in the subsequent years. “Basically, what the
policymakers propose is to reward businesses that take high risk and expect
long payback,” says Mukesh Bhutani of BMR Advisors.

It is believed that asset-heavy companies would generally find their tax

liability has come down, thanks to the new investment-linked incentives.

How tax rates influence fiscal

policy
Fiscal Policy
Fiscal policy involves the use of government spending, taxation and
borrowing to influence both the pattern of economic activity and also the level
and growth of aggregate demand, output and employment. It is important to
realise that changes in fiscal policy affect both aggregate
demand (AD) and aggregate supply (AS).

Discretionary fiscal changes are deliberate changes in direct and

indirect taxation and govt spending – for example a decision by the
government to increase total capital spending on the road building budget or
increase the allocation of resources going direct into the NHS.

1. Taxation and work incentives

Can changes in income taxes affect the incentive to work? This remains a controversial
subject in the economic literature!
Consider the impact of an increase in the basic rate of income tax or an increase in the
rate of national insurance contributions. The rise in direct tax has the effect of reducing
the post-tax income of those in work because for each hour of work taken the total net
income is now lower. This might encourage the individual to work more hours to
maintain his/her target income. Conversely, the effect might be to encourage less work
since the higher tax might act as a disincentive to work. Of course many workers have
little flexibility in the hours that they work. They will be contracted to work a certain
number of hours, and changes in direct tax rates will not alter that.
The government has introduced a lower starting rate of income tax for lower income
earners. This is designed to provide an incentive for people to work extra hours and keep
more of what they earn.
Changes to the tax and benefit system also seek to reduce the risk of the ‘poverty trap’ –
where households on low incomes see little net financial benefit from supplying extra
hours of their labour. If tax and benefit reforms can improve incentives and lead to an
increase in the labour supply, this will help to reduce the equilibrium rate of
unemployment (the NAIRU) and thereby increase the economy’s non-inflationary growth
rate.
 2.

Taxation and the Pattern of Demand

Changes to indirect taxes in particular can have an effect on the pattern of demand for
goods and services. For example, the rising value of duty on cigarettes and alcohol is
designed to cause a substitution effect among consumers and thereby reduce the demand
for what are perceived as “de-merit goods”. In contrast, a government financial subsidy
to producers has the effect of reducing their costs of production, lowering the market
price and encouraging an expansion of demand.
The use of indirect taxation and subsidies is often justified on the grounds of instances of
market failure. But there might also be a justification based on achieving a more
equitable allocation of resources – e.g. providing basic state health care free at the point
of use.

3. Taxation and labour productivity

Some economists argue that taxes can have a significant effect on the intensity with
which people work and their overall efficiency and productivity. But there is little
substantive empirical evidence to support this view. Many factors contribute to
improving productivity – tax changes can play a role - but isolating the impact of tax cuts
on productivity is extremely difficult.

4. Taxation and business investment decisions

Lower rates of corporation tax and other business taxes can stimulate an increase in
business fixed capital investment spending. If planned investment increases, the nation’s
capital stock can rise and the capital stock per worker employed can rise.
The government might also use tax allowances to stimulate increases in research and
development and encourage more business start-ups. A favourable tax regime could also
be attractive to inflows of foreign direct investment – a stimulus to the economy that
might benefit both aggregate demand and supply. The Irish economy is often touted as an
example of how substantial cuts in the rate of corporation tax can act as a magnet for
large amounts of inward investment. The very low rates of company tax have been
influential although it is not the only factor that has underpinned the sensational rates of
economic growth enjoyed by the Irish economy over the last fifteen years.
Capital investment should not be seen solely in terms of the purchase of new machines.
Changes to the tax system and specific areas of government spending might also be used
to stimulate investment in technology, innovation, the skills of the labour force and social
infrastructure. A good example of this might be a substantial increase in real spending on
the transport infrastructure. Improvements in our transport system would add directly to
aggregate demand, but would also provide a boost to productivity and competitiveness.
Similarly increases in capital spending in education would have feedback effects in the
long term on the supply-side of the economy.

Automatic stabilisers include those changes in tax revenues and

government spending that come about automatically as the economy moves
through different stages of the business cycle

• Tax revenues: When the economy is expanding rapidly the amount of

tax revenue increases which takes money out of the circular flow of
income and spending
• Welfare spending: A growing economy means that the government
does not have to spend as much on means-tested welfare benefits
such as income support and unemployment benefits
• Budget balance and the circular flow: A fast-growing economy
tends to lead to a net outflow of money from the circular flow.
Conversely during a slowdown or a recession, the government
normally ends up running a larger budget deficit.
 APPENDIX TABLE 32 : DIRECT AND INDIRECT TAX REVENUES OF THE CENTRAL AND THE STATE
GOVERNMENTS
(Rupees crore)
Yea r Centre (Gross) States@ Centre and States Combined
Direct Indirect Total Direct Indirect Total Direct Indirect Total
1 2 3 4 5 6 7 8 9 10
1995-96 33,563 77,661 1,11,224 8,040 55,587 63,627 41,603 1,33,248 1,74,851
(a) 30.2 69.8 100.0 12.6 87.4 100.0 23.8 76.2 100.0
(b) 2.8 6.5 9.3 0.7 4.7 5.3 3.5 11.2 14.7
2002-03 83,085 1,33,181 2,16,266 18,151 1,24,526 1,42,677 1,01,236 2,57,707 3,58,943
(a) 38.4 61.6 100.0 12.7 87.3 100.0 28.2 71.8 100.0
(b) 3.4 5.4 8.8 0.7 5.1 5.8 4.1 10.5 14.6
2003-04 1,05,090 1,49,258 2,54,348 20,531 1,40,703 1,61,234 1,25,621 2,89,961 4,15,582
(a) 41.3 58.7 100.0 12.7 87.3 100.0 30.2 69.8 100.0
(b) 3.8 5.4 9.2 0.7 5.1 5.9 4.6 10.5 15.1
2004-05 1,32,771 1,72,187 3,04,958 24,043 1,65,045 1,89,088 1,56,814 3,37,232 4,94,046
(a) 43.5 56.5 100.0 12.7 87.3 100.0 31.7 68.3 100.0
(b) 4.2 5.5 9.7 0.8 5.2 6.1 5.0 10.7 15.7
2005-06 1,65,201 2,00,949 3,66,150 30,211 1,90,658 2,20,869 1,95,412 3,91,607 5,87,019
(a) 45.1 54.9 100.0 13.7 86.3 100.0 33.3 66.7 100.0
(b) 4.6 5.6 10.2 0.8 5.3 6.2 5.4 10.9 16.4
2006-07 2,30,181 2,43,331 4,73,512 37,579 2,14,029 2,51,608 2,67,760 4,57,360 7,25,120
(a) 48.6 51.4 100.0 14.9 85.1 100.0 36.9 63.1 100.0
(b) 5.6 5.9 11.5 0.9 5.2 6.1 6.5 11.1 17.6
2007-08 3,12,198 2,80,949 5,93,157 1,24,383 3,09,849 4,34,232 4,36,581 5,90,798 10,27,379
(a) 52.6 47.4 100.0 28.6 71.4 100.0 42.5 57.5 100.0
(b) 6.6 5.9 12.6 2.6 6.6 9.2 9.2 12.5 21.8
2008-09 3,65,000 3,22,715 6,87,715 1,39,189 3,66,117 5,05,306 5,04,189 6,88,832 11,93,021
BE (a) 53.1 46.9 100.0 27.5 72.5 100.0 42.3 57.7 100.0
(b) 6.9 6.1 12.9 2.6 6.9 9.5 9.5 12.9 22.4
2008-09 3,45,000 2,82,949 6,27,949 1,38,157 3,60,975 4,99,132 4,83,157 6,43,924 11,27,081
RE (a) 54.9 45.1 100.0 27.7 72.3 100.0 42.9 57.1 100.0
(b) 6.5 5.3 11.8 2.6 6.8 9.4 9.1 12.1 21.2
2009-10 3,70,000 2,71,079 6,41,079 1,52,545 3,94,822 5,47,367 5,22,545 6,65,901 11,88,446
BE (a) 57.7 42.3 100.0 27.9 72.1 100.0 44.0 56.0 100.0
(b) 6.3 4.6 10.9 2.6 6.7 9.3 8.9 11.4 20.3
Memo Items:
(Average)
1998-99 (a) 40.9 59.1 100.0 14.0 86.0 100.0 30.6 69.4 100.0
to 2007-08 (b) 4.0 5.6 9.6 0.9 5.2 6.1 4.9 10.8 15.7
RE : Revised Estimates. BE : Budget Estimates.
@ : Excluding States’ share in Central Taxes as reported in Central Government budget documents.
(a) : Represents percentages to total tax revenue.
(b) : Represents percentages to GDP.
Source : Budget Documents of the Central and the State Governments.
Contribution of direct and indirect tax in
revenue collection of India

Taxation

We now turn to the revenue that flows into the government’s accounts from
taxation. There are so many different kinds of taxation and the tax system
itself often appears to be horrendously complex! But one important
distinction to make is between direct and indirect taxes.

• Direct taxation is levied on income, wealth and profit. Direct

taxes include income tax, national insurance contributions, capital
gains tax, and corporation tax.

• Indirect taxes are taxes on spending – such as excise duties on fuel,

cigarettes and alcohol and Value Added Tax (VAT) on many different
goods and services
Progressive, proportional and regressive taxes
• With a progressive tax, the marginal rate of tax rises as income
rises. I.e. as people earn more income, the rate of tax on each extra
pound earned goes up. This causes a rise in the average rate of tax
(the percentage of income paid in tax). The UK income tax system is
progressive. Everyone is entitled to a tax-free income. Thereafter, as
income grows, people pay the starting rate of tax (10%) before moving
onto the basic tax rate (22%). Higher income earners pay the top rate
of tax (40%) on each additional pound of income over the top rate tax
limit. This is the highest rate of income tax applied.

• With a proportional tax, the marginal rate of tax is constant. For

example, we might have an income tax system that applied a standard
rate of tax of 25% across all income levels. If the marginal rate of tax is
constant, the average rate of tax will also be constant. National
insurance contributions are the closest example in the UK of a
proportional tax, although low-income earners do not pay NICs below
an income threshold, and NICs also do not rise for income earned
above a top threshold.

• With a regressive tax, the rate of tax falls as incomes rise – I.e. the
average rate of tax is lower for people of higher incomes. In the UK,
most examples of regressive taxes come from excise duties of items of
spending such as cigarettes and alcohol. There is well-documented
evidence that the heavy excise duty applied on tobacco has quite a
regressive impact on the distribution of income in the UK.

DIRECT & INDIRECT TAX

PROJECTBY-HARSH SACHDEV
ROLL-39
SYBBI MMK
Country
Bangladesh
China
Indonesia
Philippines
Exp 1
0.74
Medium-term fiscal multipliers: the impact on GDP of a
permanent increase (decrease) in government expenditure
(tax) by 1% of GDP
1.91
0.59
0.55
Exp 2
2.07
12.87
2.13
4.47
Tax
0.16
1.03
0.61
0.27
Note: Medium-term is defined as the period from 2008-10.
Table 4.4. Effectiveness of Automatic Stabilizers: Expenditure
Adjustment
Shock to
Consumption
Investment
Exports
Bangladesh
0.01
-0.01
-0.04
-0.02
-0.04
-0.02
China
0.07
-0.06
0.08
-0.06
0.08
-0.06
Indonesia
-0.05
0.24
-0.12
0.25
-0.05
 0.23
Philippines
0.04
0.09
0.05
0.05
-0.03
0.03
Notes:
(a) The upper figures correspond to smoothing as defined in Eq. (1) in Section 2. The
italicized lower figures correspond to smoothing as defined in Eq. (2).
(b) The smoothing power is measured for the period of the shock and the year
immediately after (2006-7).
Table 4.5. Effectiveness of Automatic Stabilizers: Tax Adjustment
Shock to
Consumption
Investment
Exports
Bangladesh
0.00
0.00
0.01
0.00
0.01
0.00
China
-0.01
0.01
-0.01
0.01
-0.02
0.01
Indonesia
0.04
0.15
-0.02
0.16
0.04
0.14
Philippines
-0.04
0.01
-0.03
0.02
-0.08
0.03
Notes:
(a) The upper figures correspond to smoothing as defined in Eq. (1) in Section 2. The
italicized lower figures correspond to smoothing as defined in Eq. (2).
(b) The smoothing power is measured for the period of the shock and the year
immediately after (2006-7).
 Table 3.1. GDP Growth Rate: Bangladesh, China, Indonesia, and the
Philippines; 1990-2005 (in percent)

Country
Bangladesh
China
Indonesia
Philippines
1990-1999
(Average)
2000
5.9
8.4
4.9
4.4
2001
5.3
8.3
3.8
1.8
2002
4.4
9.1
4.4
4.4
2003
5.3
10.0
4.9
4.5
2004
6.3
10.1
5.1
6.0
2005
5.4
9.9
5.6
5.1
4.8
10.0
4.3
2.8
Table 4.1. Short-term fiscal multipliers: the impact on GDP of an
increase (decrease) in government expenditure (tax) by
1% of GDP for one year
Country
Bangladesh
China
Indonesia
Philippines
Exp 1
0.40
0.29
0.22
0.27
Exp 2
0.79
1.57
0.76
0.74
Tax
0.13
0.44
0.16
0.03
Note: Short-term is defined as year contemporaneous with the shock and the year after,
i.e. (2006-7).
Table 4.2. Medium-term fiscal multipliers: the impact on GDP of an
increase (decrease) in government expenditure (tax) by
1% of GDP for one year
Country
Bangladesh
China
Indonesia
Philippines
Exp 1
-0.05
0.59
0.02
0.00
Exp 2
-0.02
3.83
0.19
1.36
Tax
-0.05
0.06
-0.03
0.09
Note: Medium-term is defined as the period from 2008-10