Finance minister P Chidambaram has recently indicated a reduction in tax rates in an environment of the economy growing rapidly. The minister also indicated that the government ought to be prepared to act on a premise that the revenues would nevertheless be more buoyant.

Mr Chidambaram has shown that India was clued on to global trends, and that it was willing and able to adopt fiscal reforms that were aimed at making the economy more competitive and receptive to foreign investment. With a huge requirement of investment in the infrastructure sector, the country should do all it can to attract investments at a globally competitive cost.

In recent times, cross-border investments have grown significantly, and developing economies are attracting investment from the developed ones. These economies fiercely compete with one another for attracting foreign investment. Competitive tax rates are an obvious carrot to foreign investors and, recognising this, some developing economies in the Asia-Pacific have already taken steps to reduce their tax rates from the next fiscal.

Take the case of China and Singapore. From the next fiscal, Chinas tax rates are slated to go down from 33% to 25%. Singapore, too, seems to have taken a leaf out of Chinas book with its government announcing a 2% cut in the corporate tax rates in the 2007 budget, reducing the rate to 18%. Elsewhere in the world, Turkey has reduced its tax rate from 30% and Bulgaria from 15% to 10%. According to KPMGs tax rate survey, 2007, reductions are in the pipeline in Germany, Spain and the UK and, possibly, in France also.

The KPMG corporate tax rate survey, 2007, also throws up another interesting insight. The surveys main conclusion is that competition among countries to attract and keep foreign investment is continuing to drive down corporate tax rates across the world.

But initial indications suggest that governments are seeking to make up for the shortfall in tax revenues by increasing indirect taxes, which may require companies to shoulder greater compliance and accounting standards. An example of this is Singapore which while reducing the corporate tax rate by 2%, increased its goods and services tax (GST) by the same percentage point.

This policy was clearly spelt out by Singapore prime minister Lie Hsein Loong in the Singapore Parliament. He said if we have to bring our corporate tax rate down, every percentage point we bring it down will cost us $400 million per year. It is big money. Therefore, we need to consider raising indirect taxes, in other words the goods and services tax. It is now 5%. I think we need to push it up to 7%. Even 7% will be lower than nearly all other countries which have GST or VAT. But if we raise it from 5% to 7%, it will give us precious extra resources to implement social programmes.

According to the survey, indirect taxes appear to be playing an important role in the revenue-gathering strategy of many countries. Increasing indirect tax rates while reducing corporate tax rates is a difficult policy for governments to follow, because the link between higher indirect taxes and higher prices is obvious to any one who buys goods and services, but the link between lower corporate tax rates and increased inward investments is less understood.

Perhaps, the concern that prompts countries to raise indirect tax rates while lowering corporate tax rates is the potential reduction in tax collections. Indian tax-GDP ratio is not among the highest in the world and tax evasion, though considerably reduced, continues to exist. That is why the taskforce set up by the government under the chairmanship of Vijay Kelkar considered this aspect in detail in its report published in December 2002. The report laid emphasis on reduction in tax rates coupled with an increased focus on curbing tax evasion.

A reduction in tax rates should, however, encourage tax compliance, and with buoyant tax collections expected due to increase in compliance, the government can afford to take the initial steps to reduce tax rates.

Another valid point raised by Mr Chidambaram was exemptions to select industries and select areas need incentivising. This again is a welcome step and is a change in thought process from the earlier one which regarded exemptions as being unnecessary. Here also, the example of China is available for guidance.

The Chinese model for grant of tax incentives is interesting and worth a closer look. Broadly in policy terms, the Chinese government appears to have a mindset of granting complete tax exemption to taxpayers in agriculture, animal husbandry, forestry, environmental protection, etc.

Another key area where complete tax exemption is provided is for investment in or operation of public infrastructure projects. So, like India, China also being an economy which is growing, realises the need to incentivise investment in key growth areas, and is willing to provide a tax exemption/incentive for investment in and operation of public infrastructure facilities.

The industries that the minister has highlighted for grant of tax exemptions are food processing, electronic hardware, leather products and hotel and tourism. These and other sunrise sectors, if encouraged, will help the economy grow. The Indian economy is poised at a stage where it can really step on the gas and move into a different growth plane. Pragmatic fiscal planning is essential to facilitate this. It is heartening that international best practices have been looked at and intended to be implemented in this regard.

Sudhir H Kapadia
(The author is executive director, KPMG)