The Finance Minister, in his Union Budget 2015 speech, had announced the Government’s intention to reduce the corporate tax rate from 30% to 25% over the next four years, and phase out or rationalize various tax incentives. In November 2015, the Central Board of Direct Taxes (CBDT) released for public comments a draft proposal to implement the above road map.
In today’s globalized economy, a country’s tax code structure is an important factor for businesses when they decide where to invest. Many countries, in recent years, have recognized this and moved to reform their tax codes to be more competitive. The Indian Government’s proposal for a phased reduction in the country’s corporate tax rate would improve the competitiveness of the economy. The corporate tax rates reduction would be accompanied by the removal of tax incentives and deductions.
While the benefits of exemptions are limited to those who can gain access to them, rate cuts apply to corporate entities across-the-board. It must also be recognized that in recent times, other countries have increased their tax revenue-to-GDP ratio not by increasing tax rates, but by simplifying tax rules and widening the tax base.
Countries have used tax incentives to achieve a variety of different objectives — not all equally compelling on conceptual grounds. Some of the often-stated objectives include stimulating investment, reducing unemployment, promoting specific economic sectors and addressing regional development needs. A crucial consideration that bears on the decision to grant tax incentives should be their cost-effectiveness. Their use should be centered on the belief that the economic benefits expected from an increase in the incentive-favored activities would actually outweigh the total costs of the tax incentives granted.
Granting tax incentives entails costs in the form of:
(a) Distortions between investments granted incentives and those without incentives
(b) Forgone revenue (on the assumption that the lost revenue would have to be compensated from alternative distortive taxes)
(c) administrative resources required to administer them and prevent abuse of tax incentive provisions. While these costs could be substantial, the economic benefits that could be attributed solely to tax incentives are less clear and not easily quantifiable. Hence, the cost-effectiveness of tax incentives is often questionable.
Tax incentives may have been justified in an era when the marginal tax rates were high. However, with a phased reduction in corporate tax rates, tax incentives should be discouraged. This will contribute significantly to aligning taxable income and book profits. With such an alignment, corporate profits would bear the full burden of corporate tax. It would, therefore, be possible to further simplify the corporate tax system by eliminating other distortions such as Minimum Alternate Tax as well as the current system of dividend taxation, as retained earnings would have also borne full tax.
It is also important to recognize that much ground has shifted in the global tax debate. Many countries (including those with relatively lower corporate tax rates) have enacted the so-called “patent or innovation box” regime in order to spur innovation and domestic manufacturing. The regime grants a lower tax rate on profits from intangibles, “boxing” them off from rest of the system.
On 29 July 2015, US Senior House Ways and Means Committee members Charles Boustany and Richard Neal released an “innovation box” discussion draft. The draft proposes a 10.15% effective corporate tax rate on a portion of US corporate profits derived from qualifying intellectual property (IP). IP includes patents, inventions, formulas, processes, designs, patterns, and know-how (and the sale of products produced using such IP), as well as other types of IP such as computer software. Other countries such as the UK, the Netherlands and Ireland have been creating “innovation boxes” or special lower tax rates for IP-related income, typically between 5% and 15%.
Along with the road map on phasing out tax incentives, the Government should also initiate a discussion on the need to develop an “innovation box” regime in India. With a strong technology- and knowledge-driven economy, India may be in a sweet spot to attract investors who now need to ensure that such regimes are not harmful tax practices under the “nexus approach” as recommended by the OECD BEPS project, i.e., taxpayers can use IP regimes only if they show significant R&D occurs in that jurisdiction.
An innovation box regime may prove to be a catalyst to progress from “make in India” to “innovate in India.”