21 February 2013, 07:17 PM IST
It is time to think beyond legacy systems, and treating dividends as an expense is a starting point
The whole debate over levying an extra tax on the rich is misplaced. Only a tiny minority of highincome individuals pay tax honestly. Most of them avoid tax. Rather than talk about increasing the rate of tax on those who do pay tax, the government should focus on getting those who evade and avoid tax to pay up. The existing nominal rates of tax are too high and the rich are taxed less than the salaried middle class because dividends are exempt from tax in the hands of the investor . This is an anomaly that can be corrected, without much fuss. Except for the outrage over double taxation. This outrage is overdone. The company is a legal entity, separate from the shareholder . Its income and the shareholder's income are separate streams that can, and should, be taxed independently.
In any case, Class 12 national income accounting will tell you that Gross Value Added in an economy = Gross Profits (including depreciation) + wages and salaries. Once you have collected a comprehensive value added tax (or GST), you have effectively taxed the tax base once. Any income tax over and above GST or VAT amounts to double taxation. Why cry foul only over taxation of dividends?
The trouble with taxing dividends after having taxed corporate incomes is that corporate income is not being defined properly right now. A dividend represents a factor payment, alongside interest, rent, wages and salaries. Dividends are factor payment for equity capital. It is not an income transfer, but payment for a service, the service of making risk capital available to the company.
While accounting national income, going back to Class 12, you arrive at Gross National Income by adding net factor payments abroad to Gross Domestic Product. This element of net factor payments abroad includes cross-border payments of dividends. This principle of economic accounting is violated when it comes to taxation. All factor payments other than dividends are accepted as expense, but dividends are not. Corporate tax is charged treating dividend as the company's income.
This is conceptually wrong. Dividend should count as an expense and only retained profits treated as company income. Dividends should accrue to investors and be taxed as their personal income at the marginal rate of tax that applies at their level of income. The dividend distribution tax as a proxy for a tax on dividend income might have made sense in some distant past when every share was not dematerialised and every rupee of dividend income was not creduted to a bank account linked to a demat account. There is no administrative complexity to deducting tax at source at the highest marginal rate when dividends are paid out. If there are some investors who subsist below the poverty level and yet invest in stocks, they can claim a tax refund. The process of refunds should be smoothened, that is all.
Won't this dramatically impact the government's revenue? Not if some other complementary changes are also made. One is to abolish the distinction between short-term and long-term capital gains, and tax capital gains, subject to indexation, as business income . Two, also apply the Exempt-Exempt-Tax regime to all savings, doing away with the distinction between longterm and short-term savings. Any saving deployed in an asset would be exempt from tax, the accretion of value of the asset would be exempt from taxation while it appreciates, but the value would be taxed when realised as income (subject to indexation). These two steps together would ensure that portfolio churns — when savings are moved from one asset to another, by selling one and buying the other — do not attract taxation and that only income gets taxed. A third complementary step that is required is in regulatory procedure, to make it easy for companies to raise equity at short notice, if they need to.
Once these are in place, dividend payout by companies would go up sharply. This would attract new investors to the stock market. Stock prices would go up. The resultant capital gains, once booked, would yield a lot of tax.
The efficiency of capital would increase system-wide . Since companies can raise money at short notice when they spot a growth opportunity that calls for investment, they would not carry money on their books needlessly. Surpluses would be paid out to investors rather than maintained as low-yield reserves . Investors would redeploy these funds in ways that maximise returns. A larger number of production ventures would obtain capital. An because dividends are treated as an expense along with interest payments, companies would junk their debt bias, releasing additional bank finance for lending to companies otherwise squeezed out of the market for credit. Financial transaction taxes only reduce the efficiency of allocating both capital and risk and should be scrapped, for such efficient deployment of capital to materialise.
When investment in stocks turns extremely profitable, people would move savings out of gold and real estate. More wealth and income would leave audit trails, leading to a wider tax base. A wider tax base would allow rates of tax to be brought down even as tax collections rise as a share of GDP.
Before you get to live happily ever after, of course, someone has to act pretty brave, as any fairy tale would tell you. That could be problem, admittedly. But the whole world is rethinking taxes. Business is global , taxation is national, leading to profit shifting and base erosion. A radical overhaul is due, and should be based on economic accounting. Nothing prevents India from setting an example for the rest of the world.
