Tax reforms announced

In August 2009 India's government announced the first major overhaul of its tax system in almost 50 years. The plan aims to tackle widespread evasion and narrow the country's growing fiscal deficit. It will encourage greater compliance by lowering corporate and personal income tax rates, simplifying the rules and cancelling many exemptions.

The proposals, outlined in a discussion document released by Finance Minister Pranab Mukherjee  are focussed on direct taxes - i.e. taxes on the incomes of (natural and unnatural) persons, rather than indirect (e.g. sales and value-added) taxes.

Corporate tax rates on Indian companies will fall from 30 percent to 25 percent, and thresholds for personal income taxes will rise, reducing the number of taxpayers in top brackets. Branch profit taxes for foreign companies will also be substantially reduced.

If parliament supports the plan, the new code will take effect in April 2011.

Raising tax compliance, especially among small businesses and the informal sector, could contribute significantly to improving public finances. India, with almost 1.2 billion people had just 31.5 million taxpayers in 2006.

The fiscal deficit grew to 6.8 percent of GDP in the 2009/10 budget. While some of this is due to stimulus spending to offset lower global demand, there is significant pressure from markets for the government to get its house in order.

Greater compliance will also allow the government to lower the tax burden on Indians who currently do comply with tax laws. This will increase the disposable income, particularly for the burgeoning middle class.

India's tax laws date from an era when socialist principles prevailed in policy making. This lead to confiscatory tax rates - the highest rate was 97% in the 1970s - and very widespread evasion. While governments have progressively lowered marginal tax rates, they still confront the legacy of this period in terms of a low tax-to-GDP ratio.

The tax take was 11.5 percent of GDP last year (the historic low was about 2 percent). Furthermore, incremental amendments to the 1961 Income Tax Act have made it difficult for taxpayers to understand

Rather than attempt to amend the Act further, the Central Board of Direct Taxes has endeavoured to draft the new code starting with a clean slate.

In line with tax reforms around the world over the last 30 years, India's reform proposals aim to widen the tax base by lowering rates and reducing opportunities for avoidance and evasion. It will also consolidate various laws and amendments in a unified code and simplify the language of tax law.

Why is it important?

Tax reform will increase the disposable income of salaried workers - a significant consumer segment, but one which lacks opportunities for evasion. This should improve demand for imported consumer goods over time. Reform will also help to shore up public finances, which should be mildly positive for market confidence and borrowing costs. Perhaps most importantly, reform should make it easier for companies doing business in India to comply with tax laws.

What are the opportunities?

As noted above, tax reform will make doing business in India more attractive by reducing compliance costs and reducing the tax penalty for non-resident companies operating there. Opportunities might also be presented by the significant changes in tax accounting and tax administration practices occasioned by the new code.

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