Challenges and Reforms in India’s Taxation System | 28 Jan 2025

Source: IE 

Why in News? 

The current tax system, particularly under the Goods and Services Tax (GST) framework, retards growth that hinder business development, suppress consumption, and damage India’s investment reputation. 

How is the Tax System in India? 

• About taxes: Taxes are mandatory financial charges or levies imposed by a government on individuals, businesses, or property to fund public services and government operations. 
  • There is no quid pro quo between the tax payer and the public authority. 
  • The Tax System in India consists of a mix of Direct Taxes, Indirect Taxes and Other Taxes. 
• Types of Taxes: 
  • Direct Taxes: They are paid by individuals or entities to the government and cannot be transferred to others. 
  • Indirect Taxes: They are levied on goods and services, collected by intermediaries from consumers at the point of sale, and remitted to the government. 
  • Other Taxes: These taxes are levied for specific purposes, often funding infrastructure or welfare programs. 
• Direct Taxes:  
  • Income Tax: It is imposed on income that is progressive in nature, with different slabs for various taxpayer categories. 
  • Capital Gains Tax: Tax on gains from investments, with different rates for short-term and long-term holdings. 
  • Securities Transaction Tax: Tax on transactions involving securities in the stock market. 
  • Perquisite Tax: Tax on benefits provided by an employer to employees (e.g., housing, cars). 
  • Corporate Tax: Tax paid by companies on their earnings, with different slabs for various income levels. 
    • Minimum Alternative Tax (MAT): MAT ensures companies pay a minimum tax, set at 18.5%. 
    • Fringe Benefit Tax (FBT): Tax on non-cash benefits provided by employers (abolished in 2009). 
    • Dividend Distribution Tax (DDT): Tax on dividends paid by companies. 
    • Banking Cash Transaction Tax: Tax on banking transactions (abolished in 2009). 
• Indirect Taxes:  
  • GST: A consumption-based tax on value-added goods and services (ad valorem tax), levied at each stage of the supply chain.  
    • It is regressive in nature as it is imposed at the same rate on all individuals irrespective of income. 
  • Value Added Tax (VAT): Tax on goods sold, applied at each stage of the supply chain. It is imposed on goods that are excluded from the GST regime like alcoholic beverages, petroleum products etc. 
  • Custom Duty & Octroi: Taxes on imported goods (Custom Duty) and on goods crossing state borders (Octroi). 
  • Excise Duty: Tax on goods manufactured within India. 
• Other Levies (Cess): 
  • Education Cess: A 2% tax to fund educational initiatives like developing classrooms, libraries, providing scholarships etc. 
  • Swachh Bharat Cess: Tax introduced in 2015 to fund cleanliness initiatives like  Swachh Bharat Mission. 
  • Krishi Kalyan Cess: Tax introduced in 2016 to support agricultural welfare like irrigation projects, subsidized seeds etc. 

What are the Challenges in the Current Taxation System? 

• Retrospective Taxation: The 55^th GST Council’s recommendation for a retrospective tax amendment is a regressive move that disregards Supreme Court (SC) rulings. 
  • The ill-advised retrospective amendment to nullify the Vodafone verdict resulted in an international penalty of Rs 8000 crore, which India had to pay. 
    • In 2014, the former Finance Minister Arun Jaitley termed retrospective taxation “tax terrorism”. 
  • This erodes investor confidence and discourages long-term investments, as companies cannot rely on consistent rules.  
• Revenue Maximisation: The GST Council’s single-minded focus on maximizing revenue results in arbitrary and exaggerated tax demands, leading to business frustration and inefficiencies. 
• Input Tax Credit Denial: Denying businesses input tax credit, particularly in sectors like real estate, is economically detrimental.  
  • This increases the final price for consumers, distorts market competition, and dampens sectors that could stimulate growth. 
  • In the Chief Commissioner of Central Goods and Service Tax & Ors. Vs Safari Retreats Case, 2024, the SC ruled that the real estate sector can claim Input Tax Credit (ITC) on construction costs for commercial buildings used for renting or leasing purposes that was earlier not allowed. 
• Complicated Tax Structure: The multiple tax rates in both indirect and direct taxes, complex tax notifications, complicated system of exemption and concessions, and circulars create an environment that benefits tax professionals rather than businesses.  
• Low Direct Tax Collection: Corporations, particularly multinationals, use transfer pricing to shift profits from high-tax to low-tax jurisdictions, reducing their tax liabilities. 
  • Some corporations underreport their income or overstate their expenses to reduce their tax liability. 
  • Such low direct tax collection forces the government to generate revenues from other sources like high indirect tax rate, surcharge, and cess. 

What are the Consequences of Complex Tax Structure? 

• Imports Dependency: A burdensome tax system makes domestic manufacturing less competitive compared to imported goods, leading to over-reliance on foreign products. 
  • E.g., imports from China increased from USD 70 billion in 2018-19 to USD 100 billion in 2023-24. 
  • It also leads to inverted duty structure where the rate of tax on inputs used is higher than the rate of tax on the finished goods. 
    • The share of manufacturing in India’s GDP has fallen below 15%.  
• Currency Depreciation: As businesses face higher costs, reduced competitiveness, and suppressed growth, it leads to weakening of the Indian rupee and escalating the trade deficit. 
  • It can lead to twin account deficits when a country has both a fiscal deficit and a current account deficit.  
• Investment Discouragement: A complicated tax system, with unclear structures and retrospective amendments, creates uncertainty for investors and negatively impacts ease of doing business. 
• Lower Revenue Collection: Businesses struggle to navigate the complex tax system, resulting in either underreporting or tax evasion.  
  • Lower revenue collection forces the government to resort to higher taxes to meet fiscal targets, which leads to a cycle of stagnation. 
• Downward Economic Spiral: Lower growth, reduced investment, and rising imports create a vicious cycle that undermines long-term economic stability and perpetuates inefficiencies. 

Way Forward 

• Streamline GST: A more simplified and uniform tax rate structure should be introduced to ensure ease of doing business, especially in sectors like real estate and infrastructure. 
  • India must focus on simplifying the tax framework by rationalizing rates. E.g., three GST rates on popcorn i.e., Unlabelled (5%), Labelled ready-to-eat (12%) and Caramelized (18%). 
• Tax Certainty: Avoid frequent amendments or arbitrary tax demands that are essential to establish clear and consistent tax rules. 
  • End retrospective taxation that has been detrimental to investor confidence.  
• Optimize Revenue Collection: Leverage digital platforms and artificial intelligence to improve tax collection efficiency and prevent evasion.  
  • Technology can help in identifying tax anomalies, ensuring businesses report accurately, and preventing underreporting. 
• Focus on Economic Growth: The tax system should prioritize long-term growth over revenue maximization, as a growth-oriented policy expands the tax base in the future. 
• Improving Corporate Tax Collection: Conduct regular and thorough audits of corporate tax filings to identify potential underreporting, evasion, or fraud.  
  • Offer incentives like early payment discounts or lower penalties for early voluntary disclosures of tax errors or omissions to encourage companies to pay taxes on time.