India’s government, confronting a sharp rise in its fiscal deficit amid expanding social welfare programmes, has unveiled plans for a substantial reform of its archaic tax code, which it hopes will curb widespread tax evasion.

The reforms proposed by Pranab Mukherjee, the finance minister, aims to encourage better compliance with tax laws by lowering rates, simplifying rules, and eliminating exemptions that have eroded the tax base.

In a document published late on Wednesday [August 12, 2009], the minister proposed sharp increases in the personal income thresholds that obligate taxpayers to move to higher tax rates. 

He also plans to lower the tax rate for local companies from around 30 per cent to 25 per cent.

The government hopes that by lowering the tax burden and simplifying tax rules, more of its citizens will pay up in full, raising the government’s revenue base in the long-run.

“The thrust of the Code is to improve the efficiency and equity of our tax system by eliminating distortions in the tax structure, introduce moderate levels of taxation and expanding the tax base,” Mr Mukherjee said.

The government is also proposing the elimination of some tax exemptions as “the tax base has been eroded through a steadily escalating range of exemptions” over the years.

India has struggled for years to find ways to increase its low tax-to-GDP ratio, the legacy of extremely punitive socialist era tax rates – which peaked at 97 per cent in the 1970s and encouraged widespread evasion.

Over the last two decades, India has gradually lowered personal income tax rates, while the tax-to-GDP ratio, once as low as 2 per cent, gradually rose to around 9.2 per cent in 2003-04, and then hit a high of around 11.5 per cent in the just completed financial year.

But with India’s fiscal deficit widening to around 6.8 per cent this year, up from 6.2 per cent last year, as the government steps up spending on programmes such as a rural employment guarantee scheme, New Delhi is facing tremendous pressure to take stronger measures to put its financial house in order.

Some market analysts have expressed optimism about the tax reform proposal. “It’s an event of great significance,” said Vallabh Bhansali, a Mumbai-based financial analyst with ENAM Consultants, on an Indian financial news programme. “It’s an indication of government commitment to take the reforms forward.”

Writing in The Economic Times, Mukesh Butani, a tax adviser at BMR Partners, called the proposals “path-breaking and reformative,” saying the sharp hike in income thresholds for higher tax rates “should encourage voluntary declaration and reap long-term benefits to increase [the] tax-to-GDP ratio.

”The new tax code is intended to take effect starting from April 2011, and must first be approved by Parliament, which is expected to take up the matter in the winter session. The bill would replace the Income Tax Act of 1961.

Copyright The Financial Times Limited 2009.

By Amy Kazmin in New Delhi and Justine Lau in Hong Kong

Published: August 13 2009 05:11 | Last updated: August 13 2009 08:24