India’s tax collections — decoding the dynamics

India’s Tax Collections have presented a unique picture as personal income taxes have surged ahead of corporate taxes. Many have attempted to explain this phenomenon – & provided numerous explanations behind this which includes the recent tax cut for corporates announced in September 2019. Many have even pointed at high profits yet low tax collections as evidence in support of this hypothesis.

Taxation is always a tricky subject, as it is not just limited to economics but is more related to the politics of distribution. However, rationality in terms of meeting the overall objective of promoting a taxation structure that enhances growth while mobilizing additional revenues must be the hallmark behind such taxation policies. It was with this idea that in a joint article with Dr Surjit S Bhalla we explored a Laffer Curve analysis on India’s corporate taxes. A consequence of the exercise was that the optimal tax rate was 22 per cent – just 3 per cent lower than the previously declared corporate tax rate.

Personal income tax surged ahead of corporate tax
If indeed the corporate tax cut was revenue enhancing, then why is it that personal income taxes have surged ahead of corporate taxes in the present year? The argument that it is because of the corporate tax cuts does not pass the basic smell test for various reasons. For starters, 95 per cent of Indian corporates already had their corporate tax rates at 25 per cent in 2019. The remaining 5 per cent were no-doubt large firms, but to avail the lower tax rates they had to let go of their existing exemptions. For most of these firms, the transition to a lower rate would have been gradual as they may wait till their existing exemptions were fully claimed.

The lower tax rate of 18 per cent (15% plus cess etc.) was only for a small subset of new manufacturing companies and thus it was not valid for existing enterprises. So there too, the tax cut should not impact the fall in revenues. Therefore, to suggest that the tax cuts have reduced the corporate tax collections is not true, and perhaps more of a political point than one grounded in the underlying economic data.

Decline in corporate tax collections
But then what explains the reduced corporate tax collections? Another possible explanation is in the form of genuine income stress that corporates have faced during the pandemic. Keep in mind that for most of the companies in conventional sectors (non-IT) they saw limited income in the Covid–19 year. This includes manufacturing companies, restaurants, hotels etc. Few sectors such as pharmaceuticals, some textile companies etc. may have seen improvements in their earnings as they witnessed a surge in demand owing to the pandemic, but the rest of the sectors saw definite income stress. Therefore, that income stress would also be reflected in the reduced corporate tax filings.

Many would argue that if that is indeed the case then this should also be reflected in personal income taxes. This is indeed true, and a closer scrutiny of data is needed to decompose the extent of income stress in each of the cases. But, for individual taxpayers, we must recognize that not all of them have witnessed income stress. Given the relatively small tax base, it could indeed be the case that overall stress on personal incomes may dissipate at the aggregate level.

But what about profits? Yes, profits did improve during the pandemic, but those who cite this look at only a handful of listed companies but ignore the extent of non-listed companies which have witnessed reduced profits compared to the pre-pandemic year in an absolute sense.

Dividend Distribution Tax – a point missed by many?
A major part of the explanation somehow missed by nearly everyone pertains to the Dividend Distribution Tax. For some reason, most analysts were quick to comment on the personal income taxes surging ahead of corporate taxes even as they ignored the decision by the government to remove the Dividend Distribution Tax in Budget 2020.

Thus, dividends if issued by companies would no longer be taxed at a flat DDT rate but will now be taxed at the recipient of the dividend. Earlier, when a company issued a dividend, it deduced the DDT and transferred it to the individual who did not have to pay any additional tax on it (except for those with high dividend earnings). Post budget of 2020, dividend was treated as income of the income taxpayer and thus taxed at the appropriate tax rate as per the tax schedule applicable for the individual.

Thus, what was once booked as corporate tax revenues is now booked in personal tax revenues at an aggregate level. Moreover, the move of removing DDT and applying the appropriate income tax rate also meant a net increase of close to 5 to 10 per cent of the applicable tax rate on dividend incomes. The removal of DDT, resultant taxing at the recipient’s level & the net increase in the applicable tax rate of dividend income are responsible for the surge in personal income tax collections. That this has been ignored by many analysts has been beyond shocking for me.

Many have used the surge in personal income taxes to argue for a reduction in the personal income tax rates. Money9’s editorial, for instance made a case for rewarding the honest tax payer. Indeed, the honest taxpayers should be rewarded by rationalizing the personal income tax rates, however, this must be done independent of whether corporate tax rates are higher (or lower) than personal income tax rates. The argument is for designing a modern taxation structure which adopts the Direct Tax Code and is geared towards a revenue enhancing tax structure. This would entail rationalization of India’s taxation structure at the peak rates, but at the same time we must also acknowledge that at the lower income levels, our tax rates are far lower than other similar economies.

There has been an honest attempt at undertaking tax reforms in the country, with the GST for indirect taxes while corporate tax cut as a subset of the overall direct tax reforms. An alternative tax structure was also proposed for personal income taxpayers, however, that seems to be a work in progress. Accelerating the personal income tax reforms should be high on priority as it will only strengthen the overall tax overhaul while further rewarding the honest taxpayers of the country. The move would supplement the numerous other interventions such as pre-filed tax forms, adoption of a tax-charter and faceless assessments which make the filing process a hassle-free affair while simultaneously reducing the prospects of harassment.