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Advisory /Working Group for the Tenth Five Year Plan (2002-2007)

Interim Report of the Advisory Group: Tax Policy and Tax Administration Reform

1. Contents, Preface, Abstract and Main Recommendations { PDF format }
2. Chapter 1: Executive Summary  
3. Chapter 2: Macro Perspective and Scope of Tax Revenue: 2000-01 to 2006-07 { PDF format }
4. Chapter 3: Tax/GDP Trends in the 1990s and Future Prospects { PDF format }
5. Chapter 4: Reform of Direct Taxes { PDF format }
6. Chapter 5: Reform of Central Excises { PDF format }
7. Chapter 6: Reform of Customs Duties { PDF format }
9. Chapter 7: A Review of State Taxes { PDF format }

[ Reports are in pdf format, Click to download Acrobat Reader ]

 


 


Executive Summary


Introduction

The Planning Commission set up the Advisory Group (henceforth referred to as the Group) in July 2000 to study tax policy and tax administration issues and make appropriate recommendations for different levels of government with the purpose of generating adequate resources for the Tenth Five Year Plan (2002-03 to 2006-07).

Two challenges faced the Group. First, the parameters for the Tenth Plan have not been set so far. Thus the Prime Minister’s urging that a 9 percent rate of growth be achieved for the Tenth Plan was used as a reference point by interpreting it as a 15 percent nominal growth target. Second, while various aspects of the tax structure have improved over time, many deficiencies remain that, when corrected, would have a negative revenue impact in the short to medium term. The Group took the option of analysing such aspects and recommending corrective action despite their potential negative revenue impact. This implies that major complementary revenue yielding measures are needed to improve the overall revenue productivity of the tax system, comprising both tax policy and tax administration, and including all levels—central, state and local—of government.


A Macro Perspective and Scope of Tax Revenue

Tax policy and tax administration reform measures have to be placed in an appropriate macroeconomic perspective for feasibility of the effort. The questions to address and the results to follow would be the following:

  1. How would the growth rates of sectors—agriculture, industry and services—be distributed? Given agricultural and industrial growth rates, the residual growth would have to come from the services sector.
  2. Which states/ regions would contribute to this growth? Successful states have registered growth of more than 3 to 4 percentage points above average, while slower states have performed almost that much below average. Should the growth strategy need to have a regional focus to achieve the 15 percent nominal target?
  3. What would be the role of government? How much national resources should it draw upon for government expenditure and, of that, how much for capital expenditure, given the persistent decline in capital expenditure over the last 15 years? Which sectors should government investment focus on?
  4. How much tax revenue and non-tax revenue should government draw upon? Given the fall in the tax/GDP ratio, the stagnation of non-tax revenue, and their relation to the fiscal deficit and sustainability of public debt, appropriate macroeconomic considerations are essential to receive definitive implications for needed resource mobilisation.
  5. Given the tax revenue target as implied, as well as the base year tax/GDP ratio, what is the incremental effort required to be obtained.
  6. How should tax revenue effort be divided into centre-state targets and tax-wise targets?

The agricultural sector is characterised by a low and falling share of GDP in the second half of the 1990s (Table II.1) and a small potential for contributing to the buoyancy of tax revenue. An annual growth rate of 3.5 – 4 percent may be expected over the next few years, given recent performance of 3.3 percent growth rate (Table II.2). Industrial growth may be expected at 8 percent given recent performance of just over 7 percent.

Achievement of 15 percent overall nominal rate of growth—an increase of 2-3 percentage points of real growth rate—would, therefore, imply a need for very high growth in the services sector at the beginning of the Plan period—as much as 11 percent—declining to 10.5 percent by the end of the Plan period (Table II.2). Slight variations are of course also possible, as indicated by various simulations carried out (Table II.3).

A strategy that attempts to increase growth would need to modify the distribution of funds to regions. A services-oriented growth would be focussed on urban centres with strong infrastructure. States with high dependence on agriculture would achieve lower growth. If governance and infrastructure improve, low performing states with unutilised potential could indeed improve performance. Special category states have such small shares in GDP that high growth rates there would make only marginal difference to aggregate GDP growth (Table II.4). The distribution of development funds (Table II.5) would need to take these factors into account.

A 9 percent real growth rate would also require fundamental changes in the structure of government expenditure. Capital expenditure, which has been crowded out in both central and state government budgets, has to be restored. Further, such expenditure would have to be in growth augmenting sectors such as power, telecommunications and roads. The composition of revenue expenditure has to shift to education and health. Though interest payments in current periods may be considered exogenous, future payments, working through the fiscal deficit and accumulation of public debt, would depend on the success of collection of tax and non-tax revenue. Table II.11 projects, for 2006-07, the revenue deficit, fiscal deficit, capital expenditure and public debt compatible with the 9 percent growth rate target.

The tax/GDP ratio reached a peak of almost 16 percent in the late 1980s and has fallen since, to 14 percent of GDP in 1999-2000. Additional tax effort has to focus heavily on the service sector. First, as GDP share of industry decreases while that of the services sector increases, the tax base becomes narrower, aggregate buoyancy of tax revenue declines, and the tax/GDP ratio falls (Table II.6). Second, states’ own tax revenue is also negatively related to the share of services.

Tax revenue targets are shown in Table II.12 consistent with expenditure restructuring needed for the 15 percent nominal growth rate. Total tax/GDP ratio would need to rise from 14.09 percent in 1999-2000 to 17.78 in 2006-07. Of this, states would need to increase the ratio from 5.29 to 6.90, reflecting rationalisation of the sales tax and smaller taxes, and future replacement of the sales tax by a value added tax (VAT). Much of the Centre’s increase comes from direct taxes and from expanding the tax base by including services, and some from central excise duties, while customs duties fall slightly.

 


Tax/GDP Trends and Future Prospects

Between 1989-90 and 1999-2000, the decline in the tax/GDP ratio has been 1.9 percentage points, mainly reflecting the Centre’s revenue loss. As a result, the Centre’s share in total tax collection has declined from 66.5 percent to 62.0 percent. Likewise, against the total tax buoyancy of 0.90, the Centre’s is 0.85.

As against this, given the macroeconomic growth target, the system’s tax buoyancy would have to jump from 0.90 to 1.26. The tax/GDP ratio should reach 17.8 percent in 2006-07, which is 3.7 percentage points above 1999-2000 (Graph III.1). Of this increase, the Centre would have to achieve 2.1 percentage points (Graph III.2) and the states 1.6 percentage points (Graph III.3). Nevertheless, the share of states vis-a-vis the Centre in the gross collection of taxes increases in the terminal year 2006-07, implying an intensified tax revenue effort by states in the Tenth Plan period.

Of central taxes, corporation income tax revenue has grown the most between 1989-90 to 1999-2000, from 1 percent of GDP to 1.6 percent of GDP. The personal income tax grew from 1.0 percent to 1.4 percent. Customs duties and excises recorded declining trends, customs duties from 3.7 percent to 2.5 percent, and excises from 4.6 percent to 3.2 percent. Given anticipated further reductions in customs tariffs and comprehensive extension of the tax credit system under the MODVAT-governed excises, it would not be prudent to assign significant efforts to indirect taxation for the Tenth Plan.

Thus, customs collections have been assigned a slight decrease in terms of GDP from 1999-2000 through the Plan period, excises a slight increase from 3.2 percent to 3.5 percent, corporation income tax a jump from 1.6 percent to 2.4 percent, and personal income tax also a significant increase from 1.4 percent to 1.9 percent. Thus, the shift in tax composition evident in recent years is expected to continue through the Tenth Plan.

State level taxes have been stable in terms of GDP between 1989-90 and 1999-2000. The sales tax remained at 3.1– 3.2 percent which accounts for about 60 percent of State’s tax revenue, and state excises at 0.8 percent. Together they comprised 74 percent of states’ tax revenue. Stamps and registration increased from 0.5 percent to 0.6 percent. Land revenue declined from 0.14 percent of GDP to 0.08 percent. The stagnancy of the professional tax at 0.07 percent of GDP points towards the need for extensive coverage of services under the tax base.

In the projections, inter-se weights of individual state level taxes as obtained in 1999-2000 (historical trends) are maintained for the Plan period. In terms of GDP, state taxes will have to increase by about 1.6 percent of GDP. Sales tax is projected to increase from 3.1 percent of GDP to 4.1 percent mainly reflecting the anticipated introduction of the VAT that would go beyond first point taxation. State excises are projected to grow from 0.8 percent of GDP to 1.0 percent. The remaining increase would have to come from other taxes. The shares of both central and state taxes for 1989-90, 1999-2000, and 2006-07 are depicted in Graph III.

 


Reform of Direct Taxes

The prevailing rates of income tax—effectively 38.5 percent for the corporate income tax and 34.5 percent (including 15 percent surcharge) for the highest marginal rate for the personal income tax—are relatively higher than those prevailing in comparable countries.

Personal Income Tax

(i) Rates

Over the years, while progressivity of rate structure has been scaled back, the exemption limit has, however, been revised to exceed inflation thereby leaving more individuals below the tax net. Further, there has also been some "bracket creep" in that inflation has dragged taxpayers into higher tax brackets.

It is recommended that the maximum marginal rate of personal income tax rate be retained at 30 percent and the surcharge be removed. Also, correction must be made to remove bracket creep from the structure by broadbasing the various brackets/slabs as indicated in (Table IV.2) even though it may lead to some revenue loss at existing levels of compliance. However, this should be done pari passu with streamlining base erosion as explained below.

(ii) Tax base

(a) Savings incentives

The base of the personal income tax remains narrow for various reasons. One aspect is tax relief for savings in specified assets. The main provisions appear in Appendix Table 2. Tax credit is governed by Section 88, deductions by Section 80L, and exemptions by Sections 10(11) and 10(15) of the Income Tax Act, 1961. Also available are deductions under Section 80CCC, 80D, 80DD, 80DDB and 80E, exemptions from long term capital gains under Sections 54, 54B, 54D, 54EA and 54EB and exemption from gift tax. Assets in incentive schemes are also exempt from wealth tax.

The scope of Section 88 has been expanded during the 1990s and the amount of tax rebate from Rs.10,000 in 1991-92 to Rs.16,000 in 2001-02. The rate at which the rebate is calculated is 20 percent even though the lowest marginal tax rate is 10 percent. The scope of Section 80L has been likewise increased and the maximum available deduction is Rs.15,000.

Taken together, the schemes do not comprise a rational whole and have built up in an ad hoc manner over time. Such schemes do not necessarily result in additional savings; rather, they encourage substitution. They have negative efficiency effects favouring debt financing, crowding out the private sector, discriminating against selected activities such as home construction out of taxed savings, and de-equalising rates of return on savings that have the same risk or holding period. For example, National Savings Certificates and provident funds enjoy deductibility of investment (Section 88) and of interest earnings (Section 80(L) or 10(11) or 10(12)), leading to inordinately high effective rates of return on these assets.

Overall, the incentives are also inequitous in that the manner in which they are offered tends to favour the richer tax payers. For example, deductions from income under Sections 10 and 80L and the provisions relating to rollover of capital gains tax favour upper bracket tax payers disproportionately. Given the complexity of the savings incentives structure (Table IV.3), inequity also arises simply from asymmetric information available to the lower income earner.

It is recommended that, ideally, tax incentives under Sections 80CCC, 88, 80L and 10 (15) of the Income Tax Act be abolished, at least in phases; that tax concessions under Sections 80D, 80DD, 80DDB and 80E be given in the form of tax credit rather than as deduction from income (to improve equity); and the rollover provision relating to capital gains under Sections 54, 54B, 54D, 54EA and 54EB be removed. This reform should eventually enable further reduction in the overall tax rate structure that should enable improved savings behaviour by all tax payers.

(b) External borrowings

Section 10(15) provides for exemption of interest paid on external borrowings at a concessional rate. However, since the lender is subjected to tax in the country of his residence, it is doubtful whether the rates of interest are truly concessional. In effect, the revenue loss on these borrowings is a gain for the foreign country's treasury. It is therefore recommended that the exemption for interest on foreign borrowings should be withdrawn.

(c) Income of Funds

Essentially, funds are in the nature of pass-throughs and therefore income received by them should be exempt, though the beneficiaries of the income should be subjected to tax. Keeping in view the administrative difficulty of collecting tax from millions of small beneficiaries, it is recommended that the income of the Funds should be subjected to tax at the lowest marginal rate of personal income tax, i.e., at 10 percent.

(d) Foreign income and remuneration

There being no economic rationale for exempting remuneration received from international organisations, and reflecting the practice in several western countries, it is recommended that the provisions of Sections 10(8), 10(8A), 10(8B) and 10(9) be deleted.

(e) Foreign exchange earnings/exports of goods and services

The Government’s decision to phase out the various incentives for foreign exchange earnings/export of goods and services is a step in the right direction. However, the Group finds no justification in the continuation of the incentives under Section 10A and 10B since the international competitiveness of exports covered under Section 10A is greater than exports from outside the special economic zones. Similarly, the incentive under Section 10B is a premium on licensing. It is, therefore, recommended that the provisions of Sections 10A and 10B be phased out.

(f) Regional/industrial development

The tax incentives under Sections 80IA and 80IB of the Income Tax Act are inefficient and inequitous. Empirical evidence also suggests that these have not significantly contributed to the industrial development of backward areas. It is, therefore, recommended that the provisions of Sections 80IA and 80IB be deleted.

(g) Income from salaries

It is recommended that the standard deduction be reduced to 10 percent of the salaries subject to a maximum of Rs. 5000 since transport allowance is already exempt from tax and most employers provide at their expense the facilities of books and periodicals.

(h) Income from self-occupied house property

The present provision for allowing of interest deduction on borrowed capital for construction of a self-occupied house property should be discontinued since it is inconsistent with the matching-principle for income determination.

(i) Charity and non-profit organisations

Indirect estimates show that the overall revenue loss reflecting these sources exceeds 8 percent of total direct tax revenue. They comprise: (1) charity; and (2) non-profit organisations (NPOs). The revenue loss from exemptions for charity alone is not inconsiderable. Charity to pre-specified organisations under Section 80G cost Rs. 713 crore of revenue loss for assessment year 1997-98, i.e. Rs. 1100 crore in current year terms or about 2 percent of direct tax collection.

Rs.3300 crore in current year terms, i.e. 6 percent of direct tax revenue, could be attributed to revenue loss on account of NPOs. There has been a proliferation of NPOs in recent years. Numerous income tax exemptions are provided to them. Many of them are inefficient such as Sections 10 (23) (i) to (iii a) and (iii ab) to (iii ae) since there is no bar imposed on the distribution of net earnings. They are also anomalous and, possibly, inequitous in that NPOs enjoying exemptions under Sections 10 (23) (iii ab) to (iii ae) coexist with for-profit organisations in their respective areas of operations. Also, the existing provisions produce tax subsidies that increase with income.

Though Sections 11 to 13 do restrict distribution, they overlap with Sections 10 (23) (iv) to (vi a) which do not restrict distribution. In any event, even if distribution of net earnings were restricted, there would be some inequity vis-a-vis for-profit enterprises because of the exemption itself. Further, no differentiation is made between donative and commercial NPOs.

It is recommended that, first, the income-based deduction for donations under Sections 80G and 80GGA should be converted to a tax credit at the lowest marginal tax rate of 10 percent—for equity reasons—without any limit as a fraction of gross income as set under Section 80G. Second, the exemptions under Sections 10 and 11 to 13 of the Income Tax Act in respect of income of charitable trusts and institutions of various categories should be restricted only to donative NPOs, to be defined as those in which 90 percent of the receipts are through donations. Third, the non-distribution constraint should be made explicit and universal.

Harmonisation of Personal and Corporate Income Taxes

If the corporate income tax rate is higher than the top personal income tax rate, it tends to lead to tax induced non-corporatisation of the business sector and less organised business activity. It is, therefore, recommended that the present corporate tax rate of 38.5 percent be lowered to 30 percent in case the top personal income tax rate is integrated at the latter rate. Or, if the prevailing personal income tax rate structure continues, the corporate income tax rate should be brought down to 34.5 percent.

Expanding the Corporate Tax Base

Corporate tax legislation all over the world, no matter how streamlined at the outset, becomes subject to a "creeping incrementalism" with respect to special concessions and provisions over time, typically through excessive depreciation allowances. This is because the corporate sector constitutes a focused interest group with financial backing. A group of so-called "zero tax companies" emerges. The result is a higher marginal tax rate for those unfortunate to be caught in the tax net.

An indirect attack through presumptive taxation may become more successful than direct attempts to reduce concessions. Such indirect methods also reduce tax evasion. Further, transfer pricing practices by multinationals to optimise on cross-country differences in corporate tax rates become less profitable. A minimum alternate tax (MAT) that targets the average tax liability across taxpayers is a method that allows to keep the marginal tax rate low.

Countries have used various bases for a MAT: Colombia on net worth, Argentina and Mexico on gross assets, Canada and the United States on exclusion of deductions, selected francophone African countries on sales, and so on. It is well known that a minimum tax based on gross assets has proved to be a good revenue earner and equitable across small and big corporations. It is also efficient in terms of reallocation of resources since non-performing companies, that are unable to pay the minimum tax in the medium term, would have to close down and reinvest capital in an area of comparative advantage. In India, however, it might be difficult to introduce given the authorities’ restrictive exit policy for businesses.

As the statutory corporate tax rate has declined significantly since 1987, India has developed a history of presumptive taxation--Finance Act, Section 115J, 1987; Section 115JA, 1996; and the present Section 115JB, 2000, which provides for a minimum tax of 7.5 percent on book profit (defined as commercial profit). A major shortcoming of the MAT is the fact that it continues to be on reported income, unmindful of the widely prevalent practice of under-reporting. The effective rate of corporate tax has been estimated to be around 21 percent as against the statutory rate of 38.5 percent.

Book profit can be easily manipulated since it is amenable to accounting changes/practices and subject to the existing tax incentives. The base of the MAT could combine a stock and a flow to appropriately reflect a plausible taxable capacity of the company. Thus it is recommended that the prevailing 20 percent dividend tax be abolished. Instead, the MAT should be reconstituted as a tax equal to the aggregate of 0.75 percent of adjusted net worth at the end of the year plus 10 percent of the dividend distributed. It would allow carry forward for setoff against future tax liability in excess of the MAT as provided in Section 115JAA. The choice of adjusted net worth reflects administrative ease. Several judicial pronouncements exist on the definition of capital employed that would serve well to both taxpayers and the administration. The revenue gain is estimated to be Rs. 7000 crores approximately.

The proposed base would be efficient since, first, it is neutral between retained earnings and dividend distribution. To the extent dividends are distributed, currently they suffer a higher rate of tax in the year of distribution. In the proposed base, if the company chooses to retain its earnings it will be penalised by the capital market and still end up paying tax on it since it would result in an accretion to net worth. Second, the greater is the performance shortfall of a company, the greater is the excess of the implicit tax rate on income actual over the prevailing corporate tax rate.

The proposed base would be equitable since it would remove the bias through depreciation allowances in favour of the manufacturing sector vis-a-vis services. The stock-flow combination also protects base erosion from inflation. When net worth is eroded by inflation, the real tax loss is partly compensated by the capital gains tax paid by shareholders. (Recall the recommendations made to improve capital gains taxation). Further, if assets are revalued periodically, the increase is reflected in an increase in the net worth. If a company chooses otherwise, it will end up paying a substantially larger liability upon liquidation.

Direct Tax Administration

The Department is currently in the process of restructuring to facilitate large scale induction of information technology (IT) and expects to mobilise Rs.10,000 crore from enhanced capability to address tax arrears and stopfilers. Over the last few years, several important steps have been taken to improve administration. They include: (1) expanding the universe of taxpayers from 12 million to 25 million, through a "1 by 6" scheme that requires any income earner who satisfies any of six given criteria to register for income tax purposes; (2) extending the scheme of tax deduction at source (TDS) so that an increasing proportion of revenue comes from this source; and (3) a genuine effort towards improvement in the quality of taxpayer service.

The Group recommends the following immediate reform measures in direct tax administration:

    1. extending the pilot voice message system of Calcutta to other centres;
    2. making available forms and returns on floppy diskettes;
    3. allowing the tax administration to print forms in private presses;
    4. developing a long term plan for non-discretionary information gathering;
    5. notifying the categories of transactions for which the Permanent Account Number (PAN) must be quoted;
    6. refusing to accept taxpayer forms by the administration without the PAN;
    7. replacing the income tax clearance certificate by simply quoting of the PAN;
    8. removing the deficiencies from the Taxpayer Master File to enable identification and notification of stopfilers;
    9. writing off arrears in cases where the identity of the taxpayer is not established beyond doubt;
    10. while reducing corruption in cases of scrutiny (detailed audit), maintaining a credible minimum deterrence level—by ensuring that a certain minimum percentage of taxpayers is scrutinised annually through a selection pattern that is secret and fair;
    11. decentralising selected expenditures to local offices that are currently consolidated at the cost of efficiency at the Finance Department level;
    12. identifying areas on which resources could be saved with the advent of IT;
    13. requiring banks to furnish information regarding collection of taxes on magnetic media;
    14. providing computers to the staff members;
    15. setting up an inter-Ministerial Committee to oversee the time bound programme for networking of all income tax offices across the country; and
    16. clearly specifying the rights and obligations of all parties and supporting institutions for greater accountability in the proposed MOU between Government and the Central Board of Direct Taxes (CBDT).


Reform of Union Excises

The structure of excises levied at the central level has been simplified considerably over the last ten years. The number and level of rates have been reduced with the current central rate at 16 percent. Credit/offset (referred to as CENVAT) is, in general, given for input tax. Nevertheless, many lacunae do remain in the overall structure, rendering it effectively complex and distorted. First, apart from the 16 percent rate, there are ancillary rates. Second, the immediate credit for tax on capital goods has been staggered over two years from the current year. Third, exemptions continue to be given on a large scale many of which appear to exist on grounds of populism, and resulting in classification disputes and adverse administration. Thus much room remains for structural reform and improved revenue productivity.

Duty Structure

While most goods are taxed at the main rate of 16 percent, higher rates exist: 40 percent for panmasala, aerated water, chewing tobacco, and motor vehicles for less than 6 persons; 32 percent for cosmetics and toiletries, tyres, polyester yarn, air conditioners, and motor vehicles for 6-12 persons; 24 percent for cement, carpets and floor coverings, tiles, and two wheelers. Others attract lower rates such as cotton and wool yarn and kerosene. Though the non-16 percent rates pertain only to a selected number of goods, the administration of multiple rates is not amenable to financial control methods (based on a self removal procedure) that have primarily replaced physical controls.

It is recommended that a two-rate structure of 16 percent together with a higher rate should be introduced. An increasing number of items are to be converged to fall under the 16 percent rate to minimise classification problems. This would be economically desirable and administratively simple. The rates would have to be adjusted for inclusion of services in the CENVAT.

There is also a multiplicity of levies that include, apart from the excise rate structure, additional excise duty (goods of special importance) in lieu of sales tax on sugar, fabrics and tobacco; additional duty on motor spirit (petrol and diesel); additional duty on textiles and textile articles (fibres, yarn and fabric) under a subsidy scheme for "controlled cloth"; and cesses leviable under miscellaneous enactments.

Separate accounts are to be maintained for each of these levies, increasing administrative and compliance costs. It is difficult to work out effective tax rates since CENVAT credit is not given for all of them. There should be a single levy under the Central Excise Act. For example, conceptually there is no reason why a central excise duty could not be charged on textiles and sugar without jeopardising a state level sales tax on these items. This is what happens with all other goods.

Base of Union Excises

The base of excise is manufacture. While many disputes have occurred over the definition of manufacture, the effective twin test is: (a) a new article should come into existence; and (b) it should be marketable. The current definition--that does not include activities that may be deemed to be manufacture such as labeling or printing a brand name--encourages segregation of manufacturing activities to avoid tax. It is recommended that the definition of manufacture be widened to include the chain of value addition by or on behalf of the manufacturer (undertaken before marketing the product) to be charged to duty.

The credit for CENVAT (earlier MODVAT) is given for tax paid on manufacture. In the case of credit/offset for tax paid on capital goods, the concept is goods "used in the factory of the manufacturer". This gives rise to less litigation than the concept "used in manufacture of final products" that is used for credit of tax paid on raw material. It is recommended that both capital goods and raw material "used in the factory of the manufacturer" should be allowed CENVAT credit.

While raw materials and capital goods both received input tax credit until 1999-2000, the credit for capital goods was staggered over two years from 2000-01 for no other than obvious revenue reasons, at the cost of economic distortions. Therefore, input tax credit on capital goods should be immediately restored by giving the credit in the year of purchase itself.

The excise base is eroded by exemptions, inter alia, for: (a) small scale industry (SSI); (b) village industry marketed with KVIC assistance; (c) specified goods supplied to various types of public institutions; (d) goods produced without power; (e) cooperative society produced tea; (f) goods produced in the North-East; (g) a number of food items including bread, spices, coffee, khandsari sugar, cereals, edible oils and several unbranded food items; (h) fertilisers; (i) ready made garments, clocks, watches upto Rs. 500, electric bulbs upto Rs. 20; (j) aircraft, ship and boat; (k) defence related ordinance factories and donations to national defence fund; and others.

Further, the formulation of exemptions is extremely complex. Of the standard publication of tariffs of 720 pages, 220 pages are devoted to exemptions. There are 90 exemptions for textiles. For small scale industry, there are 5; for exports, there are 20; for job work, there are 5, and so on. Each exemption has many entries, conditions and lists, in turn, containing hundreds of items in each list.

An intensive effort is necessary to rationalise exemptions on the same subject through abolition and merger. Conditions for exemptions must be minimised. When an item is covered under the SSI exemption scheme, there should not be any separate exemption except for some very valid reasons. SSI exemption should be extended to textiles also by replacing the individual exemptions.

SSI units receive concessional duty as well as full CENVAT credit. SSI units below a turnover of Rs. 3 crore should pay a duty of 85-90 percent of the normal rate if they opt for CENVAT credit. At least, the unutilised credit should lapse once the Rs. 1 crore exemption limit is reached. The 3 crore turnover calculation should not exclude exports and exempted goods produced by a SSI unit. SSI units must maintain all records and give a declaration. Only really small units with a turnover of Rs. 15-20 lakhs should be exempted from declaration/maintenance of records.

An important issue in expanding the base is the inclusion of services in the tax net through comprehensive taxation of services. It is important to integrate services as early as possible with the CENVAT to arrive at a full fledged VAT at the Centre, perhaps as early as in the Budget of 2002-03, rather than to continue with a separate structure of service taxation.

Administration

While the VAT mechanism reduces tax induced economic distortions by reducing cascading (or "tax on tax"), the aspect of input tax credit tends to pose specific demands on administration. A substantially faster growth in MODVAT credit vis-á-vis growth in gross revenue has caused concern regarding potential misuse of MODVAT credit invoices. A survey indicated that, besides procedural and technical offences, other violations included: (1) undervaluation of goods; (2) non-reversal of credit in respect of returned rejected inputs; (3) misuse of facility of job work; and (4) availing of credit on exempted final products; twice on the same invoice; without payment of duty; by using fraud/fake documents.

It appears that 10 percent of revenue may be lost from these factors. There is also the perception that the exempted SSI sector exacerbates the misuse of CENVAT credit invoices. As the SSI sector has no interest in CENVAT credit invoices, the invoices relating to their purchases have been misused by the non-exempted sector. Thus rationalisation of SSI exemptions from CENVAT should check evasion over and above improving the excise structure.

While many procedural improvements have been made during the last decade, anomalies continue to affect the system. Some examples should be illustrative. Union excises are levied on transactions price i.e. the price paid or payable, in reflection of commercial considerations. However, when a good is sent from factory to depot or other places of removal

duty is paid at the factory gate on a value which is the transaction value at the depot/place of removal at or about the time the goods are cleared from the factory, though the goods in question may be sold from the depot at a different price at a later date. Therefore, the depots or other places of removal should be made into duty paying agencies, with accounts-based checks and audits at regular intervals.

The new procedure that has delinked duty payment from clearance is consistent with improved administration. The fortnightly payment requirement reflects the commitment of the authorities to move towards an accounts based system of administration and audit. The fortnightly payment should be replaced by monthly payment to enhance the liquidity of units and to reduce excessively stringent accounting needs.

Despite the move towards financial control, vestiges of physical restrictions remain. When goods are returned by buyer to seller, in certain circumstances, approval is necessary from the Chief Commissioner for re-entry of goods to the factory. This is time consuming and unnecessarily exacerbates the need for tax official – taxpayer contact. Reentry should be allowed on accounts based self declaration or simple intimation to the Department.

Manufacturers may acquire spare parts for use or they may resell them. For such trading activities, approval of the Department is needed which is generally not given. Resale should be allowed on the basis of maintenance of accounts and penalty imposed in case of misuse. On the whole, therefore, excise administration should complete its movement towards financial control from physical control based methods.


Reform of Customs Duties

Rates and Exemptions

The important challenge in customs tariffs is to reduce them to comparable international levels. In that light, the basic tariff rate should be reduced from 25 percent to 20 percent. This will reduce the need for exemptions. However, this can be done only with removal of the multiple exemptions that continue to erode the base.

As in the case of excise, in any standard publication of the customs tariff structure containing 1150 pages, 406 pages describe 121 exemptions, some of which have "conditions" and "lists". This is further compounded by separate Exemptions Notifications under the Additional Duty, Special Duty, and Special Additional Duty. The complexity in interpreting the exemptions may only be imagined, veritably adding to the discretionary power of lower level customs administrators. In addition, the economic distortions created can be expected to override the seeming simplification in the nominal tariff structure achieved over the last decade.

Many of the exemptions have to be removed. The zero customs duty allowed under notification 85/99 should be removed as it is hurting the capital goods industry which is not doing well at all. The countervailing duty (CVD) of 16 percent should be levied uniformly so that the question of refunding the terminal excise duty (which is associated with the CVD) is eliminated. Exemptions from the 4 percent special additional duty (SAD) should be removed. Thus fertiliser, coal mining, power generation projects, setting up of crude petroleum industry should be subjected to SAD.

Export Valuation

While in the case of excises and imports transaction value has been introduced, in the case of export, the "deemed value" continues. This lack of uniformity has led to much confusion. Transaction value should be adopted since international prices vary from transaction to transaction. This is also supported by Article 1 of the World Trade Organisation (WTO) agreement. The change can be made by adding an explanation to Section 14(1) of the Customs Act.

Treatment of Exports

There are many schemes for export promotion, remission, exemption and entitlement, including Duty Free Replenishment Certificate (DFRC), DEEC, Export Promotion Capital Goods (EPCG), export under bond, drawback, and special scheme for gem/jewellery/diamonds, Export Processing Zone etc.. These tend to create problems for administration since they are linked to export obligations over a period of years. Some of them are superfluous when others exist. They may not be compatible with World Trade Organisation WTO conventions. There is a need to evaluate if the duty foregone (35-40 percent of export revenue) is compatible with export growth. There is no need for so many export promotion schemes. They need to be rationalised by combining them and removing the overlapping. For this, the authorities should immediately constitute a time-bound Expert Group to examine the schemes and recommend an appropriate scaling back.

Administrative Matters

Many countries are beset with corruption in customs administration. This is worsened by a complex tariff structure since it encourages adminsitrators to summon taxpayers for "explanation" of classification categories sought. Simplification of the tariff structure and computerisation of procedures, enabling a reduction in the customs official – taxpayer nexus, have helped check the problem of evasion in many countries. In India, computerisation in customs administration is progressing and improvement is an ongoing process. Much remains to be accomplished, however, and speeding up is essential.

Immediate improvements are possible in customs procedures. For example, delay in the clearance of imported cargo in airports and ports was reported by trade and industry. Delay increases cost of production, congestion, under-utilisation of port facility and corruption. Despite computerisation, it was found that, given 300 clearance documents per day, 18 percent were subjected to queries. Thus, of 54 queries in a single day, 42 percent asked for catalogues, 25 percent asked for provisional duty bond without indicating reason, and the rest for chemical tests and other documents.

In sum, the Fast Track Clearance Scheme (STCS) is highly restricted and has not produced the desired result on a sufficient scale. While in excise self removal scheme applies to everybody, the STCS is only for those with "unblemished record". To speed up clearance, based on examination of practices in Canada, Holland, the United Kingdom and the United States, and recalling that not much large evasion has been detected by physical examination in customs over a period of time, only targeted goods should be checked on the basis of intelligence. Thus the intelligence collection machinery should be strengthened, while selective post audit should be based on computerised information. This will modernise customs administration and minimise the source of delay and abuse.

Provision for advance rulings on classification for Non-resident Indians (NRIs) has been enacted but it is fraught with judicial formalities. This could better be done by the Central Board of Excise and Customs (CBEC) which already has a sufficient stock of technical people to do this job. The CBEC should be allowed to give advance rulings. What is important is uniformity and certainty. Further, the advance rulings should be made available to all and not be restricted to NRIs.

Interim Report of the Advisory Group: Tax Policy and Tax Administration Reform

Executive Summary

1. Introduction
2. A Macro Perspective and Scope of Tax Revenue
3. Tax/GDP Trends and Future Prospects
4. Reform of Direct Taxes
5. Reform of Union Excises
6. Reform of Customs Duties