Study the Impact of proposed

Direct Tax Code on Money

Markets in India

BFMS Term Paper

Submitted to:

Professor P.C. Narayan

Indian Institute of Management, Bangalore

Group 1

Amit Bhalotia 2008007

Dharmesh Gandhi 2008019

Saurabh Jain 2008105

14th November, 2009

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Table of Contents

1. Scope ........................................................................................................... 3

2. Taxes Framework in India ............................................................................ 3

3. Direct Taxes in India ..................................................................................... 4

4. Rationale for introducing new code ............................................................. 5

5. Salient features of proposed Direct tax code and impacts ........................... 6

5.1 Personal Taxation: For individuals, salaried class, etc: .............................. 6

5.2 Change in Saving Behaviour: ..................................................................... 7

5.3 Corporate Taxation: .................................................................................. 7

5.4 Impact of changes in MAT: ........................................................................ 8

5.5 Impact on Banking Sector: ........................................................................ 8

6. Estimation Model ........................................................................................ 9

6.1 General Concept: Money Supply ............................................................... 9

6.2 First Level of impact ................................................................................ 10

6.2 Second level of impact for the existing tax base ..................................... 11

6.3 Third Level of Impact: Change in pattern of Savings ............................... 12

6.4 Fourth Level of Impact ............................................................................ 13

7. Conclusions ................................................................................................ 14

8. References ................................................................................................. 15

Appendix .......................................................................................................... 16

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1. Scope

In this paper, we have tried to analyze the impact on money markets, due to

various changes in taxation structure under proposed tax code. Since the overall

impact on money market would be dependent on number of factors (apart from

just changed taxation structure), we have limited our scope to estimate the

changes in money supply. We have attempted to create mathematical model to

estimate the change as a function of disposal income.

2. Taxes Framework in India

The existing direct tax framework is decades old (Income Tax Act, 1961); and

has been subjected to numerous amendments from time to time, which has

further increased the complexities in taxation structure and understanding.

In August 2009, Finance Ministry released the draft of Direct Tax Code (DTC) that

seeks to revamp and simplify the Direct Tax laws & its administration. The

proposed code envisages meaningful reduction in tax rates while simultaneously

being revenue neutral for the government. It aims to achieve this by increasing

the tax base and rationalising the countless tax exemptions prevalent under

current law. The proposed changes are expected to be beneficial for number of

sectors & companies, would impact individual savings and money markets.

Coupled with the introduction of Goods & Services Tax (GST) Bill to revamp the

indirect tax regime, Government of India is overhauling the complete tax

framework and setting the stage for the next phase of growth of Indian Economy.

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3. Direct Taxes in India

Contribution of the direct taxes to GDP in India, has been increased steadily,

which is good signal. Government focus has been shifted towards realizing direct

taxes and ensuring enhanced compliance. The direct taxes contribution to GDP

has increased from 4.2% in 2004-05 to 6.9% in 2008-09; whereas indirect taxes

contribution to GDP has grown marginally from 5.4% in 2004-2005 to 6.0% in

2008-09.1

Fig: TAX to GDP Ratio

1 Source: Economic Survey 2008-09, KPMG Analysis

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4. Rationale for introducing new code

Rationale behind introducing the direct tax code was primarily to revamp and

simplify the Direct Tax law & its administration. The proposed code envisages

meaningful reduction in tax rates while simultaneously being revenue neutral for

the government. It aims to achieve this by increasing the tax base and

rationalising the countless tax incentives prevalent under current law.

Some of the key points that are expected to be addressed by introduction of new

Tax Code are:

Income Tax Act, 1961 Direct Taxes Code Bill, 2009

• Numerous amendments - perplexing for the tax payers.

• Increased cost of compliance and administration.

• Interpretation issues leading to litigation and controversies.

• Ambiguities causing conflicting judgments on same issues by the courts.

• Simple and easy to comprehend.

• Reduction in corporate tax rates – in line with global trends.

• Proposals to increase the tax base.

• Attempt to minimize litigation / tax controversies.

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5. Salient features of proposed Direct tax code and impacts

5.1 Personal Taxation: For individuals, salaried class, etc:

The Tax code proposes a significant increase in the tax slabs for personal income

tax which, if implemented, will result in a meaningful increase in disposable

income, especially benefiting FMCG and other domestic consumption companies.

The increase in tax slabs is quite substantial in view of country's per capita

income distribution, and would lead to more money availability in money markets

& banks, depending on the various factors as discussed later in the paper.

However, the code proposes to abolish the Securities Transaction Tax (STT) by

removing the distinction between long-term & short-term capital gain, effectively

taxing all capital gains at the applicable marginal tax rate. At present, the long-

term capital gains tax is Nil on equity transactions on which STT is paid and 20%

on all other assets, while the short-term capital gains tax rate is 10% on equity

transactions on which STT is paid and 30% on other assets. This increase in

capital gain tax rates is expected to partially offset the benefits from reduction in

tax rates.

Other amendments at the personal taxation front include:

• Limit for deductions of savings for individuals and salaried class will go up to

Rs three lakh from Rs one lakh (under Sec. 80C of the existing IT Act).

• The DTC proposes to introduce EET (exempt, exempt, tax) method of taxation

of savings compared to existing EEE system.

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• Surcharge and cess on education will be removed and the peak income tax

rate will be kept at 30 per cent.

• Several tax exemptions under Section 80 C of existing IT Act – like,

instalments paid on Housing Loans, contributions to ULIPs and ELSS of mutual

funds, Bank notified fixed deposits of 5-years or more, interest accrued on

NSC – will be removed.

• Interest on Housing Loan will not be allowed as deduction.

• An individual’s gross salary would include all perquisites such as rent-free

accommodation, medical reimbursements, leave travel concession, etc. and

all these will be taxed according to their respective tax slabs.

5.2 Change in Saving Behaviour:

Proposed increase in tax deduction limit on savings from Rs one lakh at to Rs

three lakh, would likely to incentivize the user for saving. However, it would be

offset in some sense by the introduction of EET norm, i.e. investments in tax

savings instruments (PPF, Insurance, etc.) will only lead to a postponement of tax

liability rather than an outright exemption as applicable at present.

5.3 Corporate Taxation:

The key amendments in the taxation structure for corporate include:

• Peak Corporation tax will be reduced from 34 per cent to 25 per cent while

surcharge and cess on education removed.

• MAT will be changed radically; new MAT rate will be two per cent (0.25 per

cent for banking companies) of gross fixed assets replacing the existing

system of 15 per cent MAT on book profits.

• MAT will be final tax and it will not be allowed to be carried forward for

claiming tax credit in subsequent years.

• Foreign companies will have to pay a branch profit of 15 per cent.

• DTC provisions will override the provisions of tax treaties, for example,

Double Taxation Avoidance Agreement with Mauritius.

• All tax exemptions will be phased out over a specified timescale.

• All area-based exemptions will be removed for corporate.

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5.4 Impact of changes in MAT:

The new system, MAT will be paid at a specified percentage of Gross assets of a

company (broadly equates to capital employed, although it is unclear whether Net

or Gross Current Assets will be considered for computation). Although intended to

widen the tax base by reducing tax evasion, the new MAT proposals appear

burdensome on several counts:

• Companies suffering genuine losses or sub-normal RoCE due to initial

gestation period or cyclical downturn would also have to pay MAT at 2% of

gross assets.

• Since service sector (contributing to almost 54% of GDP) is not capital-

intensive, it may not be impacted under MAT; but this may not be so for

capital-intensive infrastructure companies which have long gestation

periods and may be required to pay MAT even in the initial years of low or

virtually no profits.

5.5 Impact on Banking Sector:

• Change in MAT may not impact the giants, but it will affect the small-cap

& mid-cap banks like DCB, UCO etc).

• Changes would allow banks to have greater NPA provisions

• Reduced tax rates will definitely provide a big relief to banks.

• Imposition of tax at the time of withdrawal is likely to reduce

attractiveness of tax saving instruments (PPF, ULIPs, ELSS, etc), and will

alter the investment decisions.

• Banks may not be hit very much but mortgage companies like HDFC and

LIC Housing Finance would receive lesser interest income.

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6. Estimation Model

We have tried to analyze the increase in money supply

Tax Collected = Income Tax + Corporate Tax +Professional Tax + Capital Gains Tax + Dividend Tax

6.1 General Concept: Money Supply

M1: currency with public + checkable deposits with the bank (includes only short term demand deposits) M2: M1 + post office saving deposits + short term bank deposits M3: M2 + other time deposits (broad money supply) M = C + D : Money Supply

Where,

R : Reserves D: Deposits C: Currency with public M: Money Supply B: Monetary Base m : Money multiplier

Monetary base, B = C + R Reserve-deposit ratio, rr = R/D ; Currency-deposit ratio, cr = C/D

�� = (� + �)

(� + ) M = m B

m = (�� + 1)(�� + �)�

Let’s first focus on 3 levels of impact because of direct tax code on individuals and hence on money supply

������ ��� = �� − � ��(�)�

Where, x= Income and Ei is i-th exemption/deduction; here the assumption can be that if an exemption is available and is of benefit, it will be taken. Example: sec 80C benefit, home loan interest benefit

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6.2 First Level of impact

There are people who do not declare their taxes as the tax might not be deducted at

source. If the cost of compliance is very low and the cost of non-compliance

relatively high then the person might comply. Cost of compliance and non –

compliance is dependent on income tax structure, penalty clauses, investment

opportunities available with white (after-tax) money and enforcement procedures

available. Let’s try to model each of them as cost or benefit. Whether a person

complies will depend on the income, past history of compliance, tax paid if he

complies, cost of peace of mind, etc

It will be good to estimate a cost or a utility based model of compliance to find the

probability of compliance.

Let cost of compliance be C1 i.e. incremental outflow because of tax outgo. Let cost

of non-compliance be C2 (this can be money equivalent of peace of mind +

probability of penalty+ foregone investment opportunities).

Compliance if C1 < C2 i.e. C1 should be significantly lower than C2 for increased

compliance.

C1=C1(x) ; incremental outflow because of compliance

C2=C2(x) ; money equivalent of peace of mind, penalty, foregone investment

opportunity

X=income

Assuming the population income distributed as a well behaved continuous function,

need to find out for what ranges of x is C1(x) < C2(x) . The area under the curve

would give the proportion of compliance. Then add an error to each of these terms to

make the model richer and more realistic as these costs might not be the only thing

affecting compliance.

�� (�) + �� < �� (�) + ��

this simply means we look at the probability of C1 being significantly less than C2 for

a given value of x

ε1 - ε2 ∼ f ; probability distribution density function

Pr(x)= Probability of compliance at a given income x=∫-αc2-c1 f(y) dy

Let I(x) = Number of people with Income x.

Tax (x) = Tax at income x

S(x)= Proportion of disposable income in bank.

So additional money in the system=

If m= Money multiplier

Increase in Money supply because of better tax compliance

= � ∑ ! �(�) Pr(�) $1 − ���

For our purpose we can consider only that portion of population that evade taxes

under the existing tax code.

So Tax evaders: x s.t. TaxApplicable(x)

Now here the important unknown is the probability d

discrete choice we can probably attempt a close form solution using binary logit

instead of binary probit.

Here the choices are to pay tax or not to pay tax. We have currently put only income

as a factor. In presence of o

they can be included.

6.2 Second level of impact for the existing tax base

There shall be an increase in disposable income ma

decreasing. On an existing tax base this

income.

Let I(x) = Number of people with Income x.

Tax (x) = Tax at income x

disposable income in bank.

So additional money in the system=∑ ! �(�) Pr(�) $1 − ���(�)%&(�)

m= Money multiplier (=5.3-5.5 currently in Índia, from RBI site

Increase in Money supply because of better tax compliance

��(�)%&(�)

For our purpose we can consider only that portion of population that evade taxes

under the existing tax code.

So Tax evaders: x s.t. TaxApplicable(x) 0 > ActualTax(x);

Now here the important unknown is the probability distribution f(y) . Since it is a

discrete choice we can probably attempt a close form solution using binary logit

Here the choices are to pay tax or not to pay tax. We have currently put only income

as a factor. In presence of other factors having an impact which is not insignificant,

Second level of impact for the existing tax base

There shall be an increase in disposable income mainly because of direct tax rate

ecreasing. On an existing tax base this will have an impact depending on taxable

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, from RBI site)

For our purpose we can consider only that portion of population that evade taxes

istribution f(y) . Since it is a

discrete choice we can probably attempt a close form solution using binary logit

Here the choices are to pay tax or not to pay tax. We have currently put only income

ther factors having an impact which is not insignificant,

inly because of direct tax rate

will have an impact depending on taxable

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Again let x = income; I(x)= increase in disposable income; the relationship given by the

above graph;

ΣΣΣΣi Ii(x) = total increase in monetary base i.e. B

There may or may not be a change in "m" depending on cr and rr defined above.

6.3 Third Level of Impact: Change in pattern of Savings

Another level of impact is the change in saving pattern which also has an impact of cr

value.

Assume a person generally saves 40% of the income. If the person knows that when he

withdraws money from PPF or EPF, etc it would change the pattern of saving.

He might end up saving lesser for future consumption. One portion goes into increasing

cr which will reduce 'm' .

Let s2(x) be the propensity to save in demand or time deposits with the new tax code

s1(x) = propensity to save with the existing tax code; this is dependent mainly on income;

also with culture of course but we'll ignore that for the time being.

Total shift: ΣΣΣΣi [si2(x)-si1(x)] Ii(x) = Reduction in C or increase in R

Hence money multiplier will go up if savings go up, else it goes down.

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6.4 Fourth Level of Impact

ST Capital Gains Tax rate = LT Capital Gains Tax rate

Let’s model that impact as CGT(STCGR2-STCGR1, LTCGR2-

LTCGR1,DLTCG, DSTCG)

Where, CGT = capital gains tax

STCG = short term capital gain

LTCG = long term capital gain

DLTCG = dividends for LTCG

It’s important to think what’s the impact of this move of capital gains tax on

incentivizing/disincentivizing black money conversion.

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7. Conclusions

The government has stared phasing out the four-and-a-half-decade old Income

Tax Act of 1961 with a new and ‘taxpayer friendly’ Code. The Code is designed to

provide stability to the tax regime and is based on the accepted principles of

taxation and best international practices.

By decreasing the cost of compliance (lower taxes), increasing the cost of non-

compliance (GAAR) and lowering the cost of administration; the DTC will help

widen the tax base in India.

In interaction with the industry and tax experts, the Finance Minister has

identified nine areas for re-examination, including the minimum alternative tax

(MAT), capital gains tax, double taxation avoidance agreement, general anti-

avoidance rule, taxation of charitable organisations & foreign companies in India,

taxing investments at the withdrawal stage (that is EET), taxation of income from

house property in case of self-occupied property by an individual; and taxation in

case of salaried class employees.

The estimation model that we have come up with can be enriched further using

other behavioural aspects of people. This is just the impact of individual related

tax aspects. To get the complete picture we need to similarly model all other

features of the new tax code and the difference from the old tax code.

A theoretical model was attempted mainly because of the problems we faced in

finding the statistics like income distribution, tax avoidance rate, behavioural

aspects, penalty clauses,etc. However the motive has been to show that they can

be modelled and their impact can be calculated using appropriate assumptions

and approximations.

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8. References

1. RBI website (rbi.org)

2. Finance Ministry (finmin.nic.in)

3. KPMG report

4. Business Line reports

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Appendix