VAT as a trade weapon

As I explained a fortnight ago, GDP can be regarded as the sum of all incomes, or the sum of all value added in production by citizens.

The two are equal. So, we could tax all income through income tax alone or through VAT (value added tax) alone. If limited to these extremes, leftists would opt for income tax, which soaks the rich.

Leftists claim that indirect taxes are passed on to consumers and hence inflationary, while income tax is absorbed by earners and hence non-inflationary. However, income tax is notoriously hard to collect. Indira Gandhi raised the top rate to 97.5 per cent, yet collections barely exceeded one per cent of GDP. Research shows that businessmen view direct taxes as a business cost, and seek to pass these on consumers no less than indirect taxes. Depending on the top tax rate, businessfolk invest at home or take their money abroad, legally or illegally.

Far from soaking the rich, high tax rates simply move income off the books and into Swiss bank accounts. By contrast, VAT is eminently collectible and comprehensive. Producers pay VAT on inputs, and get refunds of these only if they declare and pay VAT on their output. If they conceal their output, they get no refund, and so end up paying some tax willy nilly. VAT is levied on consumption, not savings, and to that extent encourages savings and investment.

But it taxes the rich and poor alike, and to that extent is iniquitous. Countries everywhere are reducing corporate tax and making VAT their main revenue source. India should do the same. What levels of VAT and corporate tax should we aim at? Ireland is a very appropriate model.

Like India, it has risen fast as a supplier of computer software, call centres and business process outsourcing (BPO). It has imposed very low corporate taxes of 10-16 per cent on different activities, and is cutting this further to 10-12.5 per cent. Meanwhile, it has raised VAT steadily to 21 per cent. This combination of high VAT and low corporate tax rate has made Ireland the fastest growing economy in the EU. Once the poorest country in the EU, it has now caught up with Britain. Information technology (IT) is a highly mobile industry. It needs no large factories that are costly to shift to another country. So, global software and BPO firms have flocked to Ireland to save corporate tax rates, which exceeds 40 per cent in some other rich countries. India’s software and BPO companies are also booming because they pay little or no corporate tax (India has long waived this on export profits). These companies are taxable on profits from domestic sales, but these are a small fraction of total profits. However, in pursuance of WTO rules, India is gradually phasing in corporate tax on export profits.

The danger is that IT companies will react by shifting their headquarters (and global profits) to tax havens like Mauritius. Big software companies already have subsidiaries in many countries, so shifting headquarters is easy. This tragedy-in- the-making must be thwarted immediately. So, India should opt for a relatively high VAT and low corporate and income taxes. Lower direct tax rates need not mean less revenue. Russia, which is plagued by corruption and evasion much as India is, moved two years ago from a graded income tax to a flat 13 per cent. The result: Income tax collections shot up 50 per cent. India needs to aim for a flat income and corporate tax rate of say 15 per cent, with a high exemption limit of say Rs 5 lakhs. This can be done in stages, if not overnight. This will more or less exempt the middle class from income tax, and the rich will happily pay 15 per cent with no hassles or litigation. Best of all, no IT companies (or other exporters) will migrate. The clinching argument is that tax policy has now emerged as a powerful trade weapon. This has escaped attention in India’s tax debate. Under WTO rules, a country can refund exporters indirect taxes they have paid on goods like VAT, but not income or corporate tax on export profits. These rules have opened a window of opportunity that has been seized by Estonia, the fastest-growing Baltic state.

Estonia has abolished corporate tax on profits reinvested domestically, which implies close to zero corporate tax. This strategy attracts export-oriented investment. Investors treat corporate tax as a real cost. Near-zero corporate tax in Estonia reduces real costs and enables producers to undercut foreign exporters in the global market. It also enables Estonian producers to undercut imported goods in Estonia’s domestic market, where again zero tax means lower real costs. No wonder the EU and many European governments protest that Estonia’s zero corporate tax is unfair competition. However, it conforms to WTO rules. Trade advantage is an additional reason for India to opt for low direct taxes and a high VAT. The combination will make Indian producers more competitive, globally and at home. Even with no change in price at all, investment in India will become more profitable relative to other countries because of lower direct tax rates. We tend to focus too much on tax regimes of the USA or south-east Asia. Let us learn instead from Ireland, Russia and Estonia. They have shown the way ahead.

What do you think?