When the discussion is on how the government should arrive at an ideal tax rate, the debate is never ending.

Determining the tax rate at which productivity and revenues are both maximised is the subject of great political debate. It all comes down to theories on how to manage the economy.

Evidence suggests that simpler tax systems promote economic growth and can help achieve a win-win for both the government and industry. History has shown that lowering of tax rates would lead to higher revenue collection. 

If we see the tax GDP rate of India for the period 2001-02 to 2007-08, there has been a constant rise on the tax GDP ratio from 8.2 per cent to 11.8 per cent. An analysis of the corporate tax rates shows that, there has also been a gradual decrease in the effective corporate tax rate from 35.7 per cent to 33.9 per cent. You might be surprised to learn that there is actually a measure that governments use to determine just how much they can squeeze from your wallet as taxes.

Ideal tax rate

The Laffer curve, a mound-shaped indicator, was designed to find the “ideal” tax rate that would help the government, as well as the people it serves, prosper. It is found that as taxes increased from fairly low levels, tax revenue received by the government would also increase.

However, if tax rates rise beyond a point, people would not regard it as worth working hard for paying more taxes. This lack of incentives would lead to a fall in income and therefore a fall in tax revenue.

At a certain point, high taxes encourage the creation of tax shelters and encourage business activity that generates paper losses from depreciable assets rather than business activity that creates jobs and generates revenue. Money spent on plush office suites, the purchase of private jets and the leasing of luxury cars becomes more advantageous than showin more surplus only to pay tax. Conversely, lower taxes encourage business investment and high after-tax income provides a greater incentive for employees to work more. This increases economic productivity results in an increase in tax revenues despite the lower rate of taxation.

Influence of taxation

As the corporate tax collection during April to December 2007 jumped up 40 per cent to Rs 127,683 crore from the same period previous year, the main factor causing the surge appears to be taxpayer’s responses to reduced tax rates.

Lower rates generate real and financial responses from businesses, prompting them to report higher profits.

Research has found that corporations are increasingly responsive to taxes in the global economy across many dimensions.

Countries that raise corporate tax rates increase the pre-tax returns that are required of new projects because after-tax returns tend to be equalised across countries. The result is that fewer investment projects will be undertaken and capital will emigrate. With a smaller capital stock, labour productivity and wages will fall, and government revenues will be reduced.

The University of Toronto’s Jack Mintz notes that “economic studies show conclusively that business taxes significantly affect investment in a country.” His analysis show that high effective tax rates on capital result in less foreign direct investment and therefore less economic growth.

Harvard’s Martin Feldstein who heads the National Bureau of Economic Research, in a new paper on “The Effect of Taxes on Efficiency and Growth” said that cutting someone’s marginal tax from 40 per cent to 30 per cent would typically result in about 16 per cent more income being reported. With 16 per cent more income and a 10 per cent lower tax rates, tax revenues would certainly not go down. 

Global view

A wave of corporate income tax reduction is sweeping through many countries in the Organisation for Economic Cooperation and Development (OECD).

OECD countries have, on average, reduced their corporate tax rates by 14.9 per cent between 2000 and 2007.

Most notably, Germany has moved from highest to twentieth by slashing its federal rate by 49.2 per cent in seven years (i.e., from 52 per cent to 26.38 per cent). Other leaders include Ireland (a 47.9 per cent rate reduction) and Iceland (40 per cent reduction).

The average corporate tax rate among countries in Asia-Pacific is 30 per cent. In Malaysia it is 27 per cent, Singapore 18 per cent, Hong Kong 17.5 per cent, Thailand 30 per cent and Taiwan 25 per cent.

A recent study of a 15-year period beginning in 1993 shows that, the average corporate tax rates, moved down globally from 38 percent to 26.8 percent. Collection data has shown that countries having below average corporate tax rates collect higher revenue than those above average.

In India corporate tax rate is 33.9 per cent with surcharge and cess.  In addition there is a Dividend Distribution Tax of 16.99 per cent and Fringe Benefit Tax.

Though over the years the tax rates in India have significantly reduced from as high as 45 per cent in 1993, the introduction of FBT, STT and DDT have distorted the impact of such reduction in tax rates. 

Considering the range of real and financial responses to corporate taxes, reducing the overall tax rate of India to close to the global average of 27 percent is likely to stimulate large expansion of tax base overtime. Both Indian and foreign firms would invest more and there will be less incentive to shift reported profits to other countries. These will eventually maximise economic growth in India.

A modest cut in corporate tax is unlikely to result in revenue loss in the long-term. However, the goal of policy makers should be to maximise growth andt revenue will follow. It will also result in lower tax avoidance and make India a preferred destination for global investment.

The writers are Partners at KPMG India. E-mail: krgirish@kpmg.com