MAY 14, 2019

By Smarak Swain

UNDER income tax law of any country, the tax rate on some type of income is high and the tax rate on other types of income is low.

For example, in India, the tax on labour ('income from salary') is 30% of the income. Corporate income tax ('income from business and profession') is also 30%. Whereas the tax on capital ('income from capital gains') varies from 10% to 30%. The tax on long term capital gains is 20%. Tax on long term capital gains from stock market is even lower at 10%. Short term capital gains from stock market is 15%. Royalty income from abroad attracts a tax rate of only 10%. A taxpayer can avail of attractive deductions against income from house property and professional income.

Differential tax rates are prone to misuse. A tax dodger may recharacterise their business income to income from house property to suffer less tax. Similarly, business income can be coloured as capital gains to incur lesser tax. Some examples evident from rulings of Tribunals and Courts are as under:

1) A firm A takes an office space on rent from its promoter P and pays high rent. A can claim the rent as deduction on its business income. Promoter P gets standard deduction of 30% on their rental income.

2) A consultant C has to receive consultancy charge payments for giving expert advise to a firm. They can structure it in such a way that a major part of the payment is for 'purchase of knowhow'. Technical knowhow is an intangible asset, and sale of knowhow results in capital gains, not business income.

3) A firm B may award contracts of value less than the upper limit for presumptive taxation to various members of the promoter group, viz. P1, P2, P3 etc. The members of promoter group will declare income under presumptive taxation provisions at 6% of total revenue. However, they actually do not perform any significant construction work. The firm B can then claim deduction on the entire amount in its IT return.

Differential tax rates are, thus, prone to misuse. Yet, almost all countries use different tax rates for different incomes. The rationale for this lies in economics.

The economics of dual tax rate regime

Economists divide sources of income broadly into two: labour and capital. They also believe that when supply of a good is 'inelastic', it is difficult to tax it. Inelastic supply means that the quantity of the good supplied is not affected much by price. Whereas elastic supply means that the quantity of the good supplied is substantially affected by price. A perfectly elastic supply, and a perfectly inelastic supply, look as under:

When a good is more elastic, slight change in price will reduce the supply substantially. When we place a tax on any good, we basically increase the price of that good. So the effect of taxing a good is that the supply reduces. If the good is 'elastic', then the quantity supplied reduces substantially when we tax it. The quantity available in the market reduces disproportionately even when a small tax is levied. Elastic good means high price sensitivity. Since tax increases price of the good, elastic good means high tax sensitivity.

On the other hand, an 'inelastic' good is one whose supply changes minimally on change of price. As we impose tax, the price of the good increases. But the supply reduces minimally. So supply of the good in the market reduces by smaller margins even when we impose high tax. Inelastic good means low price sensitivity. Since tax increases price of the good, inelastic good means low tax sensitivity.

Now there are two sources of income (broadly): labour and capital. Labour is highly inelastic: the engineers, the doctors, the supervisors, the workers are not going away if we reduce their wage/salary. So we can afford to take a high proportion of their wage as tax. On the other hand, capital is highly elastic. If you impose a high tax on returns from capital, capital can withdraw from the market. If the return on investment is not satisfactory to the investor, the investor can move his capital to other countries. Alternately, the investor can park his capital in land or gold and not release the capital in the market.

In short, imposing a high tax on capital is risky: it will drive away capital from market and adversely impact the economy. Its unwise for the taxman to kill the golden goose. Hence, capital needs to be taxed at a low rate. However, labour is relatively inelastic. It is difficult to move labour out of the market. Hence, the taxman can afford to tax it at a higher rate.

This is the logic behind higher tax rate on labour (such as income from wages, salary, profession, business etc) but lower tax rate on capital (such as capital gains, interest income, income from intellectual capital such as royalty etc).

Economists talk about two approaches to taxation: comprehensive taxation and scheduler taxation. Under comprehensive taxation, all income is taxed at the same rate. Since all income is taxed at the same rate, there is no rate arbitrage available to a dodger. Administrative and compliance cost of a comprehensive tax system is low. I-T returns will also be simple in a comprehensive tax system. On the other hand, scheduler taxation imposes tax at higher rate on income from labour and lower rate on income from capital. It would appear that comprehensive tax system is a much better approach to taxation than the scheduler system.

Economists, however, say that scheduler taxation is the better approach for maximising revenue while minimising the impact of tax on the market economy. This is because immobile labour should be taxed as much as possible and mobile capital should be taxed just enough to retain them in your economy.

Globally countries tax capital gains at a lower rate than salary, business, and professional income. They tax rent (return on capital invested in immovable property) too at a lower rate; royalty (return on intellectual capital) is taxed at an even lower rate than capital gains.

A comparison of tax rates on different sources of income for various countries, as prepared by OECD, is as under:

In the above graph, the Marginal Effective Tax Rate (METR) of income from various sources are mapped for various countries. It is clear from the graph that almost all countries apply different tax rates on income from different sources. This increases the scope of arbitrage. New Zealand ('NZL') and Netherlands ('NLD') apply the same tax rate on all major sources of income. This is an ideal situation. The scope of rate arbitrage is low in New Zealand and Netherlands, and the cost of tax administration would be lower for the two countries in comparison to countries that tax labour and capital differentially. However, they are exceptions.

(Excerpted from the author's book Loophole Games: A Treatise on Tax Avoidance Strategies. The author is an IRS Officer of 2008 batch and the views expressed are strictly personal.)