It is that time of the year again, budget season. The pink papers are full of news about meetings the finance minister is holding with industry chambers and economists on how the budget can stimulate investment, encourage economic growth, and support the prime minister’s flagship “Make in India” program.
The prime minister and finance minister are making the right noises. The problem is, it’s now almost two years that this government has been in power. “Making the right noise” is simply not enough. There is a need for deep reforms but there is no evidence that this government has any interest in undertaking them.
Time to end corporate tax giveaways
All the ideas and suggestions being put forth focus on big business – be it reduction in the corporate tax rate, or restoring tax exemptions for SEZs (Special Economic Zones) by taking away the Minimum Alternate Tax (MAT), or Arvind Panagariya’s “coastal SEZs”. In the last budget the FM announced that tax exemptions were to be withdrawn, but left it for this upcoming budget. The revenue secretary recently said that tax exemptions are costing the exchequer two lakh crore rupees. However, the numbers are actually far higher.
According to the statement of revenue foregone presented by the ministry of finance along with the budget documents for FY 2015-16, the revenue loss on account of various tax exemptions or deductions for corporation tax is projected at Rs. 62,398 crore. An additional amount of Rs. 5,141 crore is estimated to be revenue foregone for non-corporate businesses. The total amount is over Rs. 68,000 crore. In the case of indirect taxes, the numbers are even more staggering: Rs. 1,84,764 crore for central excise duties, and Rs. 3,01,688 crore for customs duties, for the same year. These are huge numbers, totalling up to over Rs. 5,50,000 crore. Who really corners the vast majority of tax exemptions? It is big business.
Here are some specific suggestions on possible reforms in tax exemptions in corporate income tax. Take Section 10AA – export profits of SEZ units which involved revenue foregone in 2013-14 of Rs. 15,494 crore. The budget could phase out the provision allowing “unconditional” 50% deduction over an additional 5 years in subsection (1)(ii). Section 80IA, relating to telecommunication services, costs Rs. 1,221 cr, and generation, transmission, and distribution of power, Rs. 9,980 cr. Do we really need to continue to give tax incentives to these established industries? Section 80-IB – profits of oil and gas producers – costs Rs. 9,020 crore: there is ample scope here to reduce the eligible deduction. Similarly, Section 80IAB – profits of SEZ developers, with a revenue foregone of Rs. 1,403 crore – can be phased out now. There are many other such specific reforms that can be announced in the budget, but will the government display the political will to cut tax breaks for big business?
Make in India needs SMEs, not big business
What about real tax reform that would help India’s vibrant SMEs, largely excluded from the policy discourse? “Make in India”, instead of focusing on foreign MNCs, should focus on Indian SMEs.
First, some basic statistics. According to a report in the Economic Times (“SME Nation”, June 09-15, 2013), in 2013 there were as many as 4.9 crore SMEs in India. It is important to note that micro enterprises (less than 10 employees) dominate, with 94.9% of the SME sector, small enterprises (10-100 employees) account for 4.9%, and only 0.2% are medium (>100 employees). SMEs are the backbone of the job market and the economy, employing 40% of the country’s workforce, almost 8 crore persons, and contributing 17% to India’s GDP. Almost 45% of all manufacturing activity is carried out in this sector. All of this underlines how critical SMEs are to the goals of achieving higher investment, growth, and specially, jobs.
There is an urgent need to design a simple, capacity-appropriate tax regime for SMEs. SMEs find it particularly burdensome to comply with tax. According to Tax Compliance Cost Surveys for the states of Bihar and Rajasthan conducted by IFC (a member of The World Bank Group), the cost of complying with just VAT is as high as 3.5% of sales turnover. This is often more than the amount of VAT that the firm pays. The Doing Business 2016 report of The World Bank Group, which measures ease of doing business for a hypothetical SME firm, also highlights India’s poor showing in the area of tax compliance: India ranks 157th out of 189 economies on the ‘paying taxes’ indicator. It is critical to reduce costs of tax compliance for SMEs, to free their time and resources to be deployed to productive activities.
Service tax provisions require any firm with a turnover of over Rs. 10 lakh to pay this tax. As soon as their turnover crosses Rs. 9 lakh, they have to register for the service tax. A separate service tax number is required, although it is based on the PAN; several documents have to be submitted – copies of PAN card, proof of address, constitution of business, and more. Payments have to be made every quarter, and returns must be filed every six months. All of this imposes tremendous additional compliance costs on SME service providers.
Under the Income Tax Act, there exists a provision where an SME with a turnover of less than Rs. 1 crore can avail of a simplified tax calculation method if they declare a taxable income of 8% of turnover. This is a good, simplified tax alternative made available to SMEs. However, instead of one standard rate of 8%, like in other countries, three rates of 5, 8 and 10%, for retail, manufacturing, and services, respectively, could be considered. These will be more in line with the average, expected profitability of these broad sectors and hence, the provision will be more widely used.
VAT is to be done
The one tax that impacts most SMEs is VAT, which, it was hoped, would be the Goods and Services Tax (GST) by now. Now, as per the proposed GST model, most states have been demanding that the threshold be set as low as Rs. 10 lakh of annual turnover, just like in service tax. Most studies (including IFC’s) have found that the cost of compliance of these taxes is disproportionately high for SMEs. The threshold should be much higher, so as to free the vast majority of small firms from the onerous burden of compliance with these taxes. Section 44AB of the Income Tax Act prescribes that any firm with a turnover over Rs. 1 crore should have their accounts audited by a chartered accountant and file electronic tax returns. Now, in India, over 1.5 crore such firms are complying with these requirements. I would suggest that all taxes, including the service tax and VAT, should have a threshold aligned with that of section 44AB of the IT Act, that is, of Rs. 1 crore. The budget could make an announcement to this effect; this would really make tax compliance far simpler for SMEs.
The questions likely to be raised are – what will happen to all the SMEs with a turnover of less than Rs. 1 crore? Will they slip out of the tax net and become informal? What will be the impact on revenues? First of all, both the service tax and VAT have a provision for voluntary registration even under the default turnover of Rs. 1 crore. Second, states can introduce alternative, simplified taxes for SMEs, in lieu of the GST; for example, Bihar has a flat tax of Rs. 10,000 for SMEs.
For SMEs to be able to truly contribute to production, employment generation, and growth, they need to be freed of onerous compliance burdens. The budget can take the first, important step in this direction.
Rajul Awasthi leads the tax policy and revenue administration workstream for the Europe and Central Asia region of the World Bank.