How to build a sensible tax system

Indian Express, 3 November 2015.

Tax reforms are one of the highest priorities in India today. The Ministry of Finance has setup the Justice Easwar Committee that is intended to reduce the extent of conflict in this area. While this is a step in the right direction, the problem runs deeper. We require a rethinking of tax policy, of the drafting of the law, and of organisational structure. The reforms require more ambition, and the policy work needs to be adequately resourced.

Tax policy

Legal risk associated with taxation, and arbitrary actions of the tax authorities, have created a climate of fear. The first area for work is clear thinking in tax policy. If our foundations are confused, then the private sector cannot anticipate future actions, and a series of actions by the tax authorities will be internally contradictory.

As an example, in most mature countries, financial activities by non-residents are not taxed. We think different, but we recoil at the harmful consequences of taxing non-residents. This has given a messy stalemate where attempts to tax non-residents are held back by exemptions.

For example after the MAT for FPIs crisis has subsided, it is reported that the income tax authorities are now trying to establish if foreign portfolio investors have permanent establishments in India so as to create a new battlefront. This cat and mouse game arises from a mistake at the core of tax policy.

Similar concerns bedevil the taxation of firms. We have one of the highest corporate tax rates in the world, and in order to reduce the damage, we have an array of exemptions. This has created an environment of complexity, unpredictability and legal risk. The first pillar for tax reforms is sound economic thinking in tax policy.

Better drafting of law

The second pillar of work that is required is in the drafting of income tax law. Poor drafting of the law has set the stage for chronic battles between the department and the country.

A law embeds legal risk when it uses phrases like "reasonable", "public interest", "opinion" or "believe". These words could mean almost anything, depending on the reader and on his state of mind. A modern, well drafted law would not use such words. The present income tax law uses "reasonable" 59 times, "public interest" 14 times, "opinion" 76 times and "believe" 27 times. Section 147 authorises an assessing officer to reopen assessments if there is "reason to believe" there has been evasion. The average sentence length in the law is 42 words, twice that of the Indian Financial Code.

Another element of archaic drafting which bedevils the Income Tax act is the use of `provisos' which create exceptions to the general principle. The phrase "provided that" occurs 450 times in the law. Our law is founded on faulty tax policy, on top of which exceptions were introduced to mitigate the adverse consequences of bad tax policy, and this has been done using shabby drafting.

Organisation structure

The third pillar of work required is rethinking the foundations of public administration. A separation between tax policy and tax administration is required. The strategy seen in all modern countries is to place tax policy, and the drafting of the Finance Bill, in the equivalent of the Department of Economic Affairs. Tax administration should be kept away from the Ministry of Finance, at an arms length, and tax administrators should not have a say in tax policy. This reduces politicisation of tax administration, and ensures that tax policy is not distorted in ways that are attractive to tax administrators.

A recent study showed that of 3209 cases before the judiciary, the tax authorities won only 23%. An important source of problems is the present system of targets. To set targets better, we must carry out statutory tax base surveys. As an example, today, tax officers get an aggregate target such as Rs.20 crore. In a modern tax regime, a tax officer would get an aggregate target of 20 crore, along with many sub-targets: 5 crore to be collected from persons below Rs.20 lakhs a year, 5 crore from the bracket of 20-50 lakhs, and so on.

A procedural tax administration law, which is distinct from the Finance Act, is required which lays down the organisation of legislative, executive and quasi-judicial functions in tax administration. This would have many similarities with the clarification of the working of financial agencies found in the Indian Financial Code.


Justice Easwar and his team have been given a first deadline of 3 months and a total time of 1 year. A permanent technical capability is required which will think about tax policy, draft high quality law, continually refine the law based on experience and feedback, etc. For a comparison, it is estimated that 15,000 man-days went into the drafting of the Indian Financial Code by a team of over 150 people.

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