It's time to levy a flat tax

The Central Budget will be presented to Parliament by the end of the month. The elections to a few state assemblies last year revealed the vulnerability of the Congress party to defeat.

There is no better opportunity to earn the favour of the electorate before the oncoming elections to assemblies this year and Parliament next year than the presentation of the Budget with  popular proposals relating to taxation.

This is especially relevant since the middle classes account for anywhere around 300 million for whom additional income to acquire the comforts of life is an aspiration. If incomes cannot increase substantially, they would at least like to see a rise in their take-home earnings.

There is a need for reducing the income tax burden. There is no use talking about the "low" level of inflation of 3-5 per cent. This prevails after high and sustained inflations of the past. What is bothering the average consumer today is the high level of prices, not their further increases. What is the comfort that he can draw from a low inflation rate if a banana costs Rs 2 and a cup of coffee Rs 10 even in a Grade-III restaurant?

As for assets like houses, it is beyond the dream of most of the citizens given the astronomical prices prevailing. The high interest rates on mortgage and credit card loans are a potential destabiliser of the banking system.

There is already talk of the rise in non-performing assets. It could only be topped by a recession, triggered by a decline in the demand for goods and services in the absence of adequate purchasing power.

The time has come for the introduction of the flat tax - a tax with only one rate for personal incomes. It is a proposal that this writer has been making for more than a decade.

It already prevails in about 20 countries, including Russia, where it is reported to have resulted in a significant growth in tax revenues. In fact, when the income tax was introduced in India, it was a flat tax. It prevails even now in the corporate sector.

The exemption limit for individuals may be pitched at a sufficiently high level after which a flat rate may be levied. But all deductions and other exemptions (with one exception, referred to later) may be abolished.

The exemption limit and the rate  may be fixed at that level where it will be revenue-neutral. Any further rise in revenue will come from the growth of the economy. It will make the tax structure simple and assessment and refunds quicker.

The IT Department would need to look into only the correct reporting of incomes by a smaller number of assesses and not the admissibility of any deduction or exemption, which often leads to time-consuming and costly litigation. In fact, if the following proposals with good revenue potential are also accepted, the flat tax rate could be low.

There is at present no tax on dividends in the hands of the individual. Dividend taxation has seen many ups and downs but there is a case for a de novo examination. The total number of dollar billionaires in India is 36, according to the Forbes list of 2007, their total wealth adding to $191 bn.

There are other multi-millionaires also. They derive large amounts by way of dividends. It is unconscionable that they should be tax-free in a country where about 250 million people live below the poverty line. Instead of the entire dividend income being tax-free, there could be an exemption limit appropriately fixed, say, at Rs 500,000, so that small and medium investors are not adversely affected.

There are reported to be around 20 million retail investors in shares and mutual funds, most of whom are in the middle income range. As far as capital gains in shares are concerned, the long-term ones are now exempt.

This structure need not be disturbed until such time that the effect of the flat tax and the taxation of dividend income is assessed after its implementation. Today the investor goes to the market to earn quick capital gains rather than dividends.

Hence, leaving the matter as it is will provide a counter-balancing factor to any adverse consequence in the markets due to the dividend tax. In any case, as of now, the government claims helplessness in taxing capital gains because of the Double Taxation Agreement with Mauritius.

Another area requiring attention is wealth tax. For a long time the rate of wealth tax has been a uniform 1 per cent beyond the taxable net wealth of Rs 15 lakh (Rs 1.5 million).

The rate is the same for individuals, HUFs and companies. Wealth tax is payable only on so-called "non-productive assets", like motor cars, farmhouses, vacant land, jewellery, and so on, over and above the minimum exemption limit of Rs 15 lakh.

A taxpayer may own an unlimited value of shares, bank deposits, units, commercial property, industrial property, and so on, without paying any wealth tax. As a result, the revenue from this source was a paltry Rs 250 crore (Rs 2.5 billion) in each of the last two years. The exemptions were conceived at a time when most of the assets of the rich were in physical form. It is no longer so.

The incentive for the promotion of financial assets is, therefore, no longer justified. The country has the reputation of the highest growth rate in the number of billionaires in Asia in 2007 overtaking Japan in their total.

It is ridiculous that all this wealth is tax-free in the regime of a party which claims to work towards reduction in disparities in wealth and income. Hence, there should be a wealth tax on productive assets also, with an exemption limit that would not hurt the middle classes.

A back-of-the-envelope calculation indicates the revenue potential of about Rs 10,000 crore at the current tax rate.

The one objection would be that the proposal would result in a setback to the stock market. It won't. The rich entrepreneur would still be playing in the market because he can keep the bulk of the dividend income besides capital gains. And what is the marginal utility of money to a billionaire or a multi-millionaire? That money has no value is evident from the lavish expenditure on parties and weddings indulged in by the nouveau-riche, both in the business and political class. The revenue will go up substantially.

Also, the Left will support the proposal. Contrary to popular perception, the flat tax has a built-in element of progression in tax rate. The merits and demerits of the tax are described in standard references on the subject and need not be elaborated here.