News Update

Globalisation not yet dead, courtesy ally-shoring, near-shoring & re-shoring!Cloud burst - flash floods - 80 including 22 army personnel missing in SikkimI-T- Prohibition of Benami Property Transaction Act - High Court need not interfere with order sanctioning prosecution of accused person, where proceedings are at premature stage & where subsequent facts and clarifications will emerge only after prosecution is commenced: HCSoccer’s 2030 World Cup to be held in 3 countries - Spain, Portugal & Morocco + Saudi eyeing 2034 World CupI-T- Assessment order passed 3 days after issuing Show Cause Notice - Principles of natural justice contravened as Assessee barely given any time to furnish reply to notice: HCI-T- Revisionary order nowhere mentions how original assessment order is erroneous or prejudicial to revenue's interests; power of revision need not be exercised: HC40 lakhs Americans jabbed updated Covid vaccine in Sept monthI-T- Revenue must proceed on the basis that Assessee need not pay any tax, where appeal is settled in Assessee's favor - any tax paid by Assessee despite not being required to do so, is refundable - Revenue's refusal to refund such tax paid leads to unjust enrichment & is invalid in law: HCCus - Courier Imports and Exports (Electronic Declaration and Processing) Regulations, 2010 - Appellant-Courier deliberately submitted incorrect information to Department in respect of consignments imported by the Appellant - Violation of the Regulations also entail breach of trust by the Appellant - Revocation of couriers' license is upheld: CESTATQuake of 6.3 magnitude scares PhilippinesI-T- Section 153C is only an enabling provision to issue notice notwithstanding anything contained in Sections 139, 147, 148 of I-T Act; Section 153C does not preclude Department from issuing notice for re-assessment u/s 148A to complete assessment u/s 147: HCCX - Since Appellate authority has not considered the contentions of Appellants and passed non-speaking Order, Adjudicating Authority is directed to consider all the issues and after hearing the appellant to pass a reasoned order: CESTATUK fears Russia may mine black sea - Huge risk for civilian shippingI-T- Deduction u/s 80P cannot be denied solely because ITR was filed belatedly, for reasons beyond control of Assessee, more so where mandate of filing ITR within due date didnt exist in relevant AY: ITATST - Since there is no obligation on part of media/media house to give any incentive, receipt of commission/volume discount are voluntary and gratuitous in nature, interference by Tribunal in impugned order absolving liability of assessee from payment of Service Tax is uncalled for: CESTATNobel Prize for chemistry goes to three scientists for development of quantum dotsI-T - If AO has not specified charges for which he wishes to visit assessee with penalty, then penalty order is not sustainable: ITATI-T - If payee/recipient had reflected certain income in his return, he cannot be held to be in default so as to call for any disallowance u/s 40(a)(ia): ITATCabinet okays Terms of Reference for Krishna Water Disputes Tribunal - IILuaDream - CERT-In issues alert against new malware targeting telecom sectorCabinet nod to promulgation of Tenancy Regulations for 3 Union TerritoriesYet another shooting incident in Baltimore, USA; 5 persons injuredNIIF, Japanese Bank for International Cooperation to collaborate on strategies to cut carbon emissionsDress and Address in CourtsOECD brokers multilateral convention to implement Global Minimum Tax subject to tax rule
 
Economics behind different taxation rates for different heads of income

 

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.)

(DISCLAIMER : The views expressed are strictly of the author and Taxindiaonline.com doesn't necessarily subscribe to the same. Taxindiaonline.com Pvt. Ltd. is not responsible or liable for any loss or damage caused to anyone due to any interpretation, error, omission in the articles being hosted on the site)

POST YOUR COMMENTS
   

TIOL Tube Latest

A Tete-a-tete with Larry Summers





TIOL Tube brings you an interview with former US Secretary of Treasury, Mr. Larry Summers who was recently in Delhi.




Mr. Vishweshwar Mudigonda, Partner, Deloitte Touche Tohmatsu India LLP sharing his thoughts at the TIOL Awards 2022 event.