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New Dimension to India's Taxation Policy

Written by: Harsh Vardhan Jajodia - I Am Studying In Fourth Year BBA. LLB Of Symbiosis Law School, Pune
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A tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (for example, tribes, secessionist movements or revolutionary movements). India has a well-developed tax structure with a three-tier federal structure, comprising the Union Government, the State Governments and the Urban/Rural Local Bodies. The power to levy taxes and duties is distributed among the three tiers of Governments, in accordance with the provisions of the Indian Constitution. The main taxes/duties that the Union Government is empowered to levy are Income Tax (except tax on agricultural income, which the State Governments can levy), Customs duties, Central Excise and Sales Tax and Service Tax.

The principal taxes levied by the State Governments are Sales Tax (tax on intra-State sale of goods), Stamp Duty (duty on transfer of property), State Excise (duty on manufacture of alcohol), Land Revenue (levy on land used for agricultural/non-agricultural purposes), Duty on Entertainment and Tax on Professions & Callings. The Local Bodies are empowered to levy tax on properties (buildings, etc.), Octroi (tax on entry of goods for use/consumption within areas of the Local Bodies), Tax on Markets and Tax/User Charges for utilities like water supply, drainage, etc.

The Four "R"s (The Purpose of Tax)
Taxation has four main purposes: Revenue, Redistribution, Repricing, and Representation.
The first is revenue: taxes raise money to spend on roads, schools and hospitals, and on more indirect government functions like good regulation or justice systems. This is the most widely known function.

The second aspect is redistribution. Normally, this means transferring wealth from the richest sections of society to poorer sections, and this function is widely accepted in most democracies, although the extent to which this should happen is always controversial.

A third purpose of taxation is reprising. Taxes are levied to address externalities: tobacco is taxed, for example, to discourage smoking, and many people advocate policies such as implementing a carbon tax as a way of tackling global warming.

A fourth purpose of taxation is Representation (politics). Several studies have shown that direct taxation (such as income taxes) generates the greatest degree of accountability and better governance, while indirect taxation tends to have smaller effects. This last "R" is one of the most fundamental beneficial effects of taxation, but it is often forgotten.

2. Taxation Policy

2.1. During the British Raj

India experienced a period of unprecedented calamity when the region was swept by a series of frequent and devastating famines, among the most catastrophic on record. Approximately 25 major famines spread through states such as Tamil Nadu in South India, Bihar in the north, and Bengal in the east in the latter half of the 19th century, killing 30–40 million Indians.

Contemporary observers of the famines such as Romesh Dutt as well as present-day scholars such as Amartya Sen attributed the famines both to uneven rainfall and British economic and administrative policies, which since 1857 had led to the seizure and conversion of local farmland to foreign-owned plantations, restrictions on internal trade, inflationary measures that increased the price of food, and substantial exports of staple crops from India to the United Kingdom. On the other hand some other scholars have argued that, whilst the famines may have been exacerbated by British policy, they were primarily caused by drought and ecological factors.[1]

Some British citizens such as William Digby agitated for policy reforms and better famine relief, but Robert Bulwer-Lytton, 1st Earl of Lytton, son of the poet Edward Bulwer-Lytton, 1st Baron Lytton and the governing British viceroy in India, opposed such changes in the belief that they would stimulate shirking by Indian workers. The famines continued until independence in 1947, with the Bengal Famine of 1943–44 — among the most devastating — killing 3–4 million Indians during World War II. Famine relief methods were inefficient as they often involved making undernourished people do heavy labor on public works. However, there were some famines (ex. 1874 and 1907) in which English officials acted effectively. During the famine of 1897-1902 the Curzon administration spent £10,000,000 (money of the day) and at its peak 4,500,000 people were on famine relief. From the 1880s onwards British administrators built a series of irrigation canals in India, much of it for the purpose of famine prevention. [2]

After 1902 there was not a single famine in India until 1943 in Bengal. 'What the British added was above all the power of a unified an authoritarian state, which acted because it saw the danger of drought and famine to its rule'. [3]

After the major famines the British government conducted "serious investigations" into the famine. Lord Lytton's administration was particularly negligent when it came to famine relief, with disastrous results. It was Lord Lytton's belief that market forces would see that food got into famine stricken areas, therefore government aid would not be necessary and in fact would inhibit famine relief efforts.[4]

As a result of the calamity of 1877 Lord Lytton lost his job but not before he established the Famine Insurance Grant. The results of this was that the British prematurely assured that the problem of famine had been solved forever [5].

This, sadly, proved not to be the case and the complacency that resulted from it contributed to the lack of action by the Elgin Curzon abhorred the seeming indifference many Britons at home had towards famine in India 'It was the tradegy of 1876-1878 that led to the establishment of a general famine commission under Richard Strachey and the consequent adoption of a famine code'. A famine code was not adopted in Bengal however, which contributed to the disaster in 1943. In order to limit the effects of famine ‘’Successive British governments were anxious not to add to the burden of taxation”.[6]

2.2. After Independence

The government of India imposes a progressive income tax on taxable income of individuals, Hindu Undivided Families(HUFs), companies (firms), co-operative societies and trusts. The Income Tax department is governed by the Central Board for Direct Taxes (CBDT) and is part of the Department of Revenue under the Ministry of Finance. The individual income tax is a progressive tax with three brackets. No income tax is applicable on income up to INR 110,000 per year. (INR 145,000 for women and INR 195,000 for senior citizens). The highest bracket is 30%, with a 10% surcharge (tax on tax) for incomes above Rs. 10 lakh (INR 1 million). [7] All income taxes are subject to 3% education cess, applicable on the tax paid. Deductions and rebates are provided for housing purchases, rent, long term savings, and insurance.

Business income is taxed at a flat rate of 33% for Indian companies and 40% for foreign companies.[8] Dividends are income tax free to shareholders. Instead, companies are charged a 15% dividend distribution tax. Long term capital gains stands at 20% (for gold, real estate, etc.) with indexation benefits provided for inflation adjustments. For sales of shares in recognized stock exchanges, long term capital gains(held above 1 year) are not taxed, and short term gains are charged 10% tax (less than 1 year of holding) provided the Securities Transaction Tax (STT) has been paid. All other short term gains are clubbed with income in the year the gains occur.

2.3. Liberalization – A New Era

Since 1991 tax system in India has under gone a radical change, in line with liberal economic policy and WTO commitments of the country. Some of the changes are:
▪ Reduction in excise and custom duties - Excise duty on most commodities ranges between 0 to 16%. Only on seven items duty is imposed at 32%, viz., motor cars, tyres, aerated soft drinks, air conditioners, polyesters filament yarn, pan masala and chewing tobacco. Duty is charged at 30% on petrol with additional excise duty at Rs. 7 per litre. The said rates are subject to exemptions and deductions thereon as may be notified from time to time. Central VAT (CENVAT) is applicable to practically all manufactured goods, so as to avoid cascading effect on duty.

Peak customs duty reduced from 220% (in 1991) to 30% (in 2002). The general project import duty (for new projects and substantial expansion of existing projects) reduced from 85% to 25%. Import duty under EPCG Scheme is 5%. R&D imports is 5% of the customs duty. Export made with imported inputs get concessions in form of duty drawback, duty entitlement pass book scheme and advance licence. Many type of industries such as 100% EOU and units in free trade zone get facility of zero import duty. An Authority is made for Advance Ruling for foreign investor

▪ Lowering corporate Tax - For domestic companies, this is levied @ 35% plus surcharge of 5%, where as for a foreign company (including branch/project offices), it is @ 40% plus surcharge of 5%. An Indian registered company, which is a subsidiary of a foreign company, is also considered an Indian company for this purpose.

▪ Widening of the tax base and toning up the tax administration - Conventionally, the criteria of a good tax system have been classified in terms of equity, efficiency and simplicity.

(a) Equity. Whilst everyone agrees that a taxation system should be equitable or fair, there has been much debate over what constitutes equity in the distribution of the taxation burden. The most commonly accepted principle of taxation equity is the "ability-to-pay" principle. This principle states that the distribution of the burden of taxation should be commensurate with taxpayers' ability to pay tax. Those who are more able to pay tax should pay more tax. Ability to pay is normally measured by a taxpayers' annual income (possibly augmented by a measure of their wealth).

b) Efficiency. Another important criterion of a good tax system is efficiency. The taxation regime should promote an efficient allocation of the economy's scarce resources. In the absence of externalities and other types of market failure, this is normallyachieved by the tax system having the minimum possible distortionary effect on individual choices and allowing the invisible hand of market forces to achieve Pareto optimality. The choices referred to here include the choices between work and leisure, consumption and savings, the patterns of consumption, and so on.

(c) Simplicity. Compliance costs and administration costs are the two aspects of a tax's simplicity. Obviously, these two types of cost should be minimized. International studies have found that both administrative costs and compliance costs are higher for personal income tax than for broad-based consumption taxes.

3. Current Trends and Emerging Issues

Since joining the WTO in 1995, India has experienced extreme economic growth, emerging as one of the leading foreign investment tickets in Asia. This has had a dramatic impact on the local talent market, and today, local companies and multinationals are not only competing for the same customers, they are also competing for the same people. As a result, rewarding performance effectively is now a key differentiator for Indian companies as they look to attract, retain and motivate employees.

Over the last five years, an extensive research has been conducted into performance and rewards in India. The results of research identified three clear trends:
▪ A strong correlation between economic growth and salary levels;
▪ Companies are increasingly rewarding, recognizing and reinforcing performance; and,
▪ The rationalization of compensation structures.

A Strong Correlation Between Economic Growth and Salary Levels

A strong correlation between economic growth and salary levels was clearly demonstrated across many sectors, with high-performing sectors consistently recording higher pay increases.

The IT and ITeS sectors have demonstrated consistent growth over the past four years, and rank among the highest paying industries in India. Since 2001, the IT industry has seen scores of benefits from the government, making it one of India’s leading sectors. The ITeS boom began in 2003 when the sector grew by over 60 percent and revenues sky-rocketed. The year 2004 saw a Compound Annual Growth Rate (CAGR) of 64 percent, and this success continued into 2005, so it comes as no surprise that this sector has been paying higher increases with every passing year.

A similar situation arose in 2005 for asset management companies, when the sector grew by 37 percent from the previous year. SENSEX reached an all time high, which led to the mass participation of retail investors in new fund offers and many asset management companies (AMCs) expanding operations to first- and second-tier cities to increase customer reach. This, in turn, resulted in fierce competition for talent, and many companies used high salary increases to help attract and retain the best people.

In a survey conducted this year, some 99.5 percent of participating organizations said they had a formal Performance Management system (PMS) in place, compared to 97 percent in 2001. More than three quarters of participating studies ranked "pay for performance" as the top criteria in their reward strategy.
Research also demonstrates that the implementation of variable pay is also on the increase. Only 85 percent of organizations had variable pay plans in 2001, compared to 89 percent in 2005. Significantly, variable pay as a percentage of total compensation has increased from an average of 11.5 percent to nearly 19 percent across all sectors.

Many organizations today actively differentiate high performers, and in the 2005-06 study high performers received double the salary increase of an average performer.

Sectors also display differentiation in their appetite for variable pay:
Industry 2001 Variable Pay 2005 Variable Pay
Manufacturing 11% 16.20%
Banking 13.50% 23.30%
IT 10.90% 13.70%
ITeS 12.90% 16.40%
Telecommunications 14% 17.80%
Financial Services 19.20% 23.50%
FMCG 13.30% 16.50%
Research also shows that the services sectors offer variable pay more than capital-intensive sectors. The success of a services company lies in its people, and therefore service-oriented organizations are more willing to include a higher variable pay component in their compensation structures.

Furthermore, most service-oriented companies are in what are termed "new economy sectors" such as IT, telecom, ITeS, AMCs and insurance. These companies don’t have the legacy issues inherent in some of the old economy sectors, which tend to have more long-term employees.

These industries are followed by the telecom and ITeS sectors, which have been largely responsible for India’s recent high economic growth phenomenon. Unfortunately employees with the necessary skill set are limited and, therefore, companies employ aggressive incentive strategies to retain their talent.
The Fast Moving Consumer Goods (FMCG) and manufacturing sectors have traditionally been more conservative when it comes to variable pay, since organizations in these old economy sectors tend to focus on total rewards rather than on total compensation.

Compensation Structure Rationalization

Salary structures are being simplified across most industries. Historically, compensation structures comprised of 22 pay components, each to ensure that the employee paid the least amount of tax possible. In line with international structures and due to changes in the government’s direct tax policy, compensation structures have been simplified dramatically to include about six to eight items of pay. We have even seen examples in the industry of compensation structures being simplified still further to only three items of pay.

Typical structures, both past and present, are outlined below. Most organizations are either at or are moving towards "B" and "C" structures. Some, meanwhile, still follow the "A" structure, while more progressive organizations have adopted a "D" structure.

Structures vary within an industry sector depending on its maturity and employee demographics. For instance, banking and financial services, which traditionally comprised a benefits-heavy structure, are rapidly moving towards a simplified, cash-oriented model. In contrast, the FMCG and manufacturing sectors, which are simplifying their compensation structures, are still inclined towards retaining key benefits that have perceived employee value given the maturity and stability of these sectors and the relatively older employee population.

New and emerging sectors such as retail, telecom, aviation, IT, ITeS and AMCs that are free of legacy issues and have a younger employee population tend to adopt simplified structures at the outset.

There are several key causes for this trend towards rationalization:
▪ A simplified tax regime has negated the tax shelter effect that most items of pay enjoyed;
▪ Organizations using simplified structures can effect sometimes significant administrative cost savings;
▪ The employee population is becoming younger and is, therefore, more oriented towards higher cash structures and flexibility;
▪ Much stricter corporate governance norms on tax compliance in employee payroll have pushed organizations to do away with dubious “tax” items of pay.
The recently introduced Fringe Benefits Tax has significant cost implications on most benefits-heavy organizations and is pushing firms to rethink their structures.
Fringe Benefit Taxable percentage Effective Tax Rate
Medical reimbursements 20% 6.8%
Telephone bills 20% 6.8%
Employee Stock Options (Difference between market value and purchase price on vesting date) 100% 33.99%
From 1/4/2007 , Employees Stock Option Plan (ESOP) or Sweat Equity has also been brought within ambit of fringe benefit tax. Section 115WB(1)(d) specifies that any ESOP will attract Fringe Benefit Tax, and the benefit is equal to the difference between the price paid and the fair market value of the share, as determined by the Board. Tax is levied on the date of vesting of such options. "Fair Market Value" is not yet defined by the Income Tax Department [8].

4. Comparison between different countries

Income Tax rates by Country based on OECD 2005 data (includes employer payroll tax contributions that some countries impose for programs like social security and health care) [9].

5. Conclusion
India has demonstrated tremendous growth in recent years, making it one of the most competitive markets in the world. However with this growth, we have also seen the emergence of a highly competitive talent market and a rise in the cost of attracting, retaining and motivating key talent, as companies increasingly understand the importance of employing the best people. As companies continue to face a volatile business environment made worse with aggressive competition and scarce talent, the trend of giving out hefty salary increases will continue. With companies are constantly looking at meaningful ways of rewarding their workforce. Pay Plans will continue to grow in popularity. Increasingly companies will use these plans to improve competitive positioning, enhance productivity, and adjust organization and business priorities to suit the changing business environment

[1] Ferguson, NiallEmpire: The Rise and Fall of the British World Order and the Lessons for Global Power (2003). Roy, Tirthankar (2000). The Economic History of India 1857-1947. Delhi: Oxford University Press, xiv + 318pp., MacAlpin, Michelle Burge (1983). Subject to Famine: Food Crises and Economic Change in Western India, 1860-1920. Princeton University Press, 304pp. . Basic Books,
[2] Tomlinson, B.R. (1993). The Economic History of Modern India 1860-1970. Cambridge University Press, p. 86.
[3] Marshall, PJ (2001). The Cambridge Illustrated History of the British Empire. Cambridge University Press.
[4] Niall Ferguson, Empire and Lady Beatty Balfour, Lord Lytton's Indian Administration.
[5] "The Ruling Caste: Imperial Lives in the Victorian Raj" by David Gilmour page 116.
[6] See Robert Johnson, “British Imperialism” page 30
[7] Income-Tax. Taxmann Publications. Retrieved on 2007-01-24.
[8] See
[9] OECD Tax Database. Organisation for Economic Co-operation and Development. Retrieved on 2007-01-30.

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