One of the tenets of taxation is that tax collected should be proportional to the ability to pay. And this gives rise to the progressive tax structure—as incomes rise, taxpayers pay a higher share of their incomes as tax since their ability to pay tax also increases.
In the case of India, for several years this meant at the lower end people paid no tax up to a certain threshold of income, while people at the other end paid roughly 30 percent of their incomes as tax.
Through several surcharges and cesses, this highest number has gradually crept up in recent years and post this year’s budget the highest tax rate is now above 40 percent. > India's super-rich will now pay highest income tax in the world Thus, the personal tax system has become extremely progressive in recent years. Perhaps, a bit too progressive. But that is a separate discussion. The point of this piece is that in the corporate sector, we see the opposite scenario. Corporate Tax rate falls as profits increase
Source: Budget Document
The chart above depicts the effective corporate tax rate (calculated as corporate tax liability divided by profit before tax) by ranges of profit before tax (PBT).
As one can see, companies with PBT of over Rs 500 crore, have the lowest burden of the tax. The effective tax rate for companies with PBT of up to Rs 1 crore was low in FY18 because the tax rate for companies with turnover of up to Rs 50 crores was reduced to 25 percent from FY18 onwards.
In last year’s budget, this threshold of Rs 50 crores was increased to Rs 200 crores and in the budget presented last week, this was further increased to Rs 400 crores. So, the effective tax rate will fall in other PBT brackets also in the next couple of years.
The fact though remains that our corporate tax structure, as it stands today is inverted. Bigger companies pay a lower share of their profits as taxes than smaller companies.
Tax incentives/exemptions are skewed in favour of larger companies
Source: Budget Documents
And the reason for this is that tax exemptions are heavily skewed in favour of bigger companies. As the chart above shows, as the PBT increases, the ratio of taxable income to PBT falls – the difference being explained by tax exemptions.
For companies with PBT above Rs 500 crores, a third of their PBT, in aggregate, is subject to various tax exemptions. These exemptions such as accelerated depreciation or for business situated in SEZs are in addition to regular expenditure incurred in running the business. So the larger companies pay a lower share of their profits as tax since they are disproportionate beneficiaries of tax incentives.
In addition to corporate tax, companies pay a dividend distribution tax of 15 percent and, including cess and surcharge, the tax rate comes to around 17 percent.
And after paying this tax, if the shareholder or owner receives dividends aggregating to over Rs 10 lakhs, he pays a tax of 10 percent, which including surcharge and cess comes to just over 11 percent.Effectively, if a company makes a pre-tax profit of Rs 100 and if it were to distribute entire profits as dividends, the shareholders would receive just Rs 53 after all taxes have been paid. The effective tax rate on corporate profits is thus 47 percent, almost double the headline tax rate of 25 percent. And this creates multiple issues.
First, many businesses face the option of either remaining small or investing and growing. When almost half the profits are being taken away by the government, it increases the expected rate of return and thus disincentivising investments. This is true especially for smaller businesses who have the capacity to invest and grow (due to their size). And small businesses are much more capital and labour intensive relative to their larger cousins. If small businesses are being disincentivised due to the corporate tax structure, it does hurt the economy! Second, this is a way to counteract the point above. The high tax rate creates incentives to evade tax because the tax rate is perceived to be too high. This is a natural response to the point above when a business sees large profits but doesn’t like the idea of almost half of them being taken away by the government. Third, there has been a significant emphasis on ‘formalisation’ of the economy. The word ‘formalisation’ has not been defined by the government but it does connote some kind of structure or organisation to businesses. And one way businesses get formalised is through a corporate structure. Individual proprietorship businesses are more likely to be subscale informal businesses than a corporate entity doing a similar business since a corporate structure connotes scale. But if converting to a corporate structure and getting formalised entails paying a much higher tax, it clearly acts as a disincentive for formalisation. It sets the bar much higher for a business to become formalised in this way. And this goes against the policy objective of the government.
Come to think of it, there are six crore businesses in the country as per the 2013 economic census and just over nine lakh active companies that year. Thus, less than 2 percent of the business in the country use the corporate form of business. Almost 90 percent of businesses are individual proprietorships.
The corporate tax structure is not the only thing holding back formalisation or growth of small businesses or contributor to black money in the economy. There are several other reasons. Else, we would not have lakhs of active companies exist. But it surely is an important factor in their overall decision making.
The issue can be posited as follows: what would be the scenario had the corporate tax structure been more benign. Would it have encouraged more small businessmen to want to expand or grow their business and thus take up the corporate form of business? Would it encourage more small businesses to want to invest and grow their existing businesses? Would it reduce the urge to evade tax?
The reduction of the corporate tax rate for smaller businesses to 25 percent is a step in the right direction. But more needs to be done. Eliminating the dividend distribution tax is a good place to start.
Ashutosh Datar is a Mumbai-based independent economist.