HYDERABAD: If there's one thing the forthcoming budget must encompass, it's the direct tax reforms.
India first legislated income tax laws in 1860, but ironically, they were replaced only four times in the past 160 years. The last change came 59 years ago, i.e, in 1961, which not surprisingly is currently in practice and includes provisions drafted by the British.
To its credit, the present Income Tax Act, 1961 has seen a mind-blowing 2,500 amendments (through Annual Finance Acts). But the countless deletions and additions have rendered it inconsistent, with overlapping and contradictory provisions ending in protracted litigations. Income comes from only three sources - land, labour and capital.
Yet, the definition of what constitutes income at source (within India) and foreign remains a subject of intense debate, particularly if it's corporate income and sometimes even lands us in controversial long-drawn cross-border taxation disputes.
Moreover, since there have been profound changes in both law and administration of income tax over the last 50 years, tax experts believe it's high time to replace the 1961 Act incorporating international best practices.
Two recent expert committees - Arbind Modi report in 2018 and Akhilesh Ranjan report in 2019 - suggested sweeping changes, including reduction in tax rates (both personal and corporate) to phasing out exemptions to allowing tax breaks on savings including fixed deposits.
This leaves Finance Minister Nirmala Sitharaman with three choices:
One, undertake comprehensive tax reforms, meaning replace the 1961 Act in full and at once. This is bound to have complications, much like the GST rollout, which is yet to stabilize.
Two, opt for a partial, phase-wise rollout, though some argue this may not have the desired effect.
Three, ignore tax reforms and do what every Finance Minister does in general, offering some tax rebates here, raising some surcharges or cesses there.
The danger with the last two of the three options is, it not only leaves tax reforms as an unfinished agenda but also limits our ability to move towards an effective tax regime that'll augment revenue in line with growth trends.
History of income tax laws
When it started in 1860s, income tax rates were as less as 2 to 4 per cent. It was only in 1866 that the Income Tax Act, 1866 came into effect with several features, some of which are in practice even today like exemption on agricultural income. It remained in force for 32 years until 1918.
The 1918 Act replaced all tax laws, brought in tax slabs various income buckets, introduced relevant categories such as 'company' and 'previous year.' It's this law that classified taxable income into 6 -- income from salaries, securities, house property, business, professional earnings and other sources. However, it was considered ineffective and was in force for the shortest duration, ie., until 1922.
The 1922 Act shifted the administration of income tax from the hands of the provisional government to the central government. It also specified rates in the Annual Finance Act, was applicable to all income except capital gains, casual income and others. During this time, a Super Tax (loosely termed now as surcharge) was rolled out besides introducing deductions, allowances and reliefs for the first time. The system of advance tax was also brought, besides imposing capital gains tax for the first time in 1946.
In all, the 1922 Act was in force for 40 years and was amended 29 times between 1939 and 1956 to plug administrative loopholes and prevent tax avoidance and evasion. Tax rates steadily rose to meet the growing needs of the government. And by 1939, income tax collections accounted for over 20 per cent to the total tax revenue.
The 1961 Act, came into effect only in April 1962 with 298 sections and 4 schedules. But nearly every Finance Act brought changes to this Act.
Several attempts were made to rewrite the 1961 Act:
The first such exercise was done during 1986-1991, but couldn't be implemented as it was felt necessary to first undertake tax structure reforms recommended by the Chellaiah Committee in 1992.
The second attempt came in 1996, but the recommendations of the in-house group too couldn't be undertaken due to change in the government.
The third attempt was made in 2005, but it took five full years to introduce the Direct Taxes Code Bill, which was referred to the Standing Committee on Finance that submitted its report only two years later in 2012.
By then, the Lok Sabha was dissolved and finally, the exercise was abandoned in 2015. The fourth attempt to rewrite the tax laws began in 2017, and the government is now in receipt of two high-level committee recommendations.
Overhauling our archaic tax regime is essential to improve efficiency of tax income by rationalizing rates, eliminating distortion in treatment of savings, investment and financial intermediaries.
A new tax law ensures laws are written in the language of the people, facilitate compliance with an electronic-based interface with tax administration (something that Sitharaman already announced last September), eliminates discretionary powers by restructuring penalties and sanctions against non-compliance, removes ambiguity to minimize litigation and judicial abuse and lastly limits opportunities for rent-seeking.
The problem with past expert committees was finding ways to eliminate corporate tax incentives. The archaic definitions in our tax code meant, protracted litigations, profit shifting through truncated rights to taxation, evasion, transfer pricing (for instance the Vodafone deal) etc. Defining what income or payment shall be deemed to have derived from India remains unsettled. Only when these aspects are dealt with, Indian income tax laws will be on par with global best practices.
Both committee reports have crucial suggestions, but the question is will the government walk the talk?