• Ashok M, CFA

The progressive tax system and expectations from the new Direct Tax Code

Updated: Aug 21, 2019


The maximum marginal tax rates, including the revised surcharge, on high net-worth individuals and certain trusts have drawn a lot of attention to the unfairness of these rates brought about by Budget (2) of 2019. But this shouldn’t have been unexpected given that in a progressive tax system, there is no objective limit around which one deems a tax rate as objectively unfair. Such is the appeal of the progressive tax system for the taxman.


A progressive tax system is one where higher incomes are taxed at ever-higher rates of tax. There is no grandiose purpose to this method other than collecting more revenue for redistribution purposes. Income taxation, in itself, is an uncomfortable carve-out off otherwise full rights to property. Within this, progressive taxation is a socialistic conception that has outlived its staunchest critics and gravest prognosis. Today, we are inching closer to 50% maximum marginal rate which according to any reasonable minded person is confiscatory, arbitrary and dampens economic enthusiasm.


An ideal tax system should provide equal after-tax income earned from work performed during a marginal unit of time. That is when an individual undertakes a new project his cumulative income (or more importantly taxes) up to that point of time shouldn’t influence his motivation to undertake the new project. Progressive taxes precisely distort economic activities at the margin.


An ideal tax system should also be agnostic of the tax-wrapper that the business is encased in. Individuals, today, are taxed at higher marginal rates than say a company or partnership. This discourages new ventures and experiments that an innovator would like to undertake on her own before giving legal definity to the idea.


The wasted opportunities, the lost capital accumulation probability and opportunity lost in adding to long term potential growth of the economy are counterfactuals that are never accounted for or questioned in the hustle of lawmaking.


Other arbitrary conceptions brought about by taxation are time and ownership. Taxes are levied on profits accrued during a particular time duration and this is tied to ownership underlying the entity. Profits are quite uncomfortably - from the perspective of an entrepreneur with a long-term vision - compartmentalized according to calendar duration.


A fortuitous year in accounting profits is accompanied by a cheque in favor of the government. A following bad year is ignored – or at best carried forward for a tax code defined duration. If the life cycle of a business is such that there are good years followed by a series of bad years finally resulting in liquidation, the government doesn’t ‘return’ the taxes it collected when times were good. It's an asymmetric social contract.


A business cycle approach to risk-capital - at least within a regulator defined asset class such as venture capital - must be developed.


Capital must be allowed to snowball within this sector (of entrepreneurs and venture capitalists) agnostic of individual players. The restriction of losses being ‘ignored’ when substantial ownership changes must go. Risk capital must be chain-linked. A tax year should roughly coincide with the business cycle or the business plans of these ventures. Clusters of capital asset-classes must be identified. Those that are primary, binary or transient must be taxed higher than those that are intermediary or secondary in color.


Currently, separate legal entities are governed by flat or proportional tax structures while individuals (and certain trusts) are taxed at progressive rates. This distinction ideally must go. A proportional tax system solves the problem of equal reward for work done during a marginal unit of time.


A progressive tax system with usurious surcharges and cesses convey de-meritorious signals to society. At the core, it’s an envy-tax for earning income above an ephemeral absolute that few experts think is excessive. False theories of diminishing utility of incomes have been conjured up to protect it. That none has seen anybody forgo higher incomes merely because the accompanying consumption is unworthy isn’t a surprise. On the contrary, we need a system where high-income-earners are rewarded – the collateral benefit being higher savings and capital formation.


Tax codes are rigidly stuck around entity formats, slabs, usurious marginal rates, arbitrary extension or compression of time durations while it all ignores the basic function of capital in an economy. Higher business risk requires more ring-fencing from capital depleting tax exactions. Individuals – who are flesh and blood beings – need to be shielded from dissuading tax disincentives that present a twisted connection between effort and reward.


Hopefully, the new direct tax code is a game-changer. Mere reduction in the number of lines of code or pushing up the ‘progressive’ slabs or reduction in rates wouldn't suffice. For that matter, a liberal slab system could be attempted within the existing tax code itself. We need a new code that reflects coordinated fiscal and economic policy. The code must be cleaned off unprincipled extractions. Economic actors should feel only slightly worse-off after paying taxes. And certainly, relative advantages between those actors out of entity-choice or other forms of camouflages should be fully neutralized. Taxes must become easy, predictable and shouldn’t substantially alter entrepreneurial sequencing.


#tax #budget

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