ICAI Notes 5.4 - Basic Understanding of Tax System in India | Business Economics for CA Foundation PDF Download

Learning Objectives

• know the meaning of Direct and Indirect Taxes.
• know about merits and demerits of Direct and Indirect Taxes.

4.0 MEANING OF DIRECT AND INDIRECT TAXES

Tax is the most important source of revenue of the Government. A tax is a compulsory contribution from a person to the expenses incurred by the State in common interest of all without reference to specific benefits conferred on any individual. Taxes are generally classified into direct taxes and indirect taxes. Taxes which are not shifted i.e., the incidence of which falls on persons who pay them to the Government are direct taxes. Examples of direct taxes are income tax and wealth tax. Where the burden is shifted through a change in price, the taxes are indirect. Examples of indirect taxes are sales tax, custom duty, excise duty etc.

4.1 MERITS AND DEMERITS OF DIRECT AND INDIRECT TAXES

Merits of Direct Taxes :

(i) They are imposed according to the ability of the person to pay. Therefore these taxes are considered progressive.

(ii) The revenue is income elastic; because of the progressive character revenue will increase faster than the increase in income.

(iii) These taxes create better civic consciousness because the person paying knows clearly how much he has paid. This incidentally fulfils the objective of certainty.

(iv) They best serve the purpose of transference of income from the rich to the poor, through provision of amenities to the poor or even direct monetary help like old age pensions.

Demerits of Direct Taxes 

(i) The ability to pay is difficult to determine; only a rough idea can be formed.

(ii) Because of undeclared sources of income or evasion, the actual payment may not be strictly according to the ability to pay. It is also sometimes said that direct taxes are taxes on the honesty of the person.

(iii) Such taxes necessitate proper maintenance of accounts which some of the tax payers may not be able to do.

(iv) The assessment procedure is also cumbersome requiring expert assistance of tax advisers. The direct tax system is often very complicated.

Merits of Indirect Taxes

(i) The most important merit is convenience in assessment and a relative difficulty in evasion. This is because they are assessed at flat rates and realised at appropriate point such as at the factory site in the case of an excise duty on production or at point of entry in the case of imports.

(ii) Since the tax is included in the price, the consumer may not even realise that he is paying a tax. The amount of tax on each item is often so small as really not to hurt the tax payer.

(iii) Even these taxes may not be really regressive if they are levied on ad valorem basis or on the basis of value. The rates may also be differential-higher for luxury articles and lower for necessaries; the latter are sometimes fully exempt.

(iv) Such taxes are difficult to evade. Unless the producers resort to manipulation of accounts or smuggling, it is difficult to evade the excise duty. In case of customs duties, articles are taxed the moment they enter the country. However, it is difficult to make a similar claim in respect of sales tax.

(v) Indirect taxes on drinks, narcotics and tobacco, serve a social purpose by discouraging their consumption.

Demerits of Indirect Taxes: 

(i) These taxes are often criticised for their regressive character. Taxes on necessaries of life will certainly mean taxing the poor and that will mean taxing the rich and the poor alike.

(ii) Also it is contended that these taxes do not create social consciousness because they are often not felt by tax payers.

(iii) Government is not certain about the proceeds of these taxes.

(iv) The burden of indirect taxes can be shifted forward or backward. In most of the cases, the consumers have to bear the ultimate burden of indirect taxes.

(v) These taxes can also be evaded by such methods as smuggling, falsification of accounts etc.

4.2 TAX STRUCTURE IN INDIA

4.2.0 Direct Taxes in India : Under this mainly income tax, wealth tax and gift tax are included.

Income Tax : Income tax is a tax on the income of an individual or an entity. Income Tax in India was introduced in India in 1860 but was discontinued in 1873. It was reintroduced in 1886 and since then it has stayed. Since its reintroduction a number of changes have been made in its structure, rates, exemptions and other dimensions of this system. Important types of Income tax are Personal income tax and Corporate income tax. Though the State Governments have power to levy a tax on agricultural income, in practice this tax has not developed as a major source of revenue for the State Governments.

Personal income tax is levied on the income of individuals, Hindu Undivided Families, unregistered firms and other association of people. For taxation purposes incomes from all sources are added. Certain rebates, deductions, expenditure etc. on account of Life insurance, medical insurance, savings in Public Provident Fund and certain notified instruments are allowed. Whole income is divided into different slabs and it is taxed on the basis of slab into which it falls. Like all other countries India has a progressive income tax. That means, as income increases, the rate of tax also increases. There was a time when the income tax rate , inclusive of surcharge was as high as 97.75 per cent for the highest income slab. Since 1974-75, it has been brought down(in stages) to 30 per cent in 1997-98. At present also, the marginal rate of income tax (i.e., tax for the highest slab) is 30 per cent. Thus the degree of the progressivity of the income tax schedule has been considerably reduced.

Corporate Tax is levied on the incomes of registered companies and corporations. The rationale for the corporation tax is that a joint stock company has a separate entity and thus should be taxed separately.Untill 1960-61, corporations were taxed in a partial sense. A corporation was required to pay income tax on behalf of its shareholders on dividends paid to them, and each shareholder got a credit to this effect. Since 1960-61, corporations are being treated as independent entities and shareholders are not given any credit. Though the corporates are being taxed at a flat rate, there are provisions for various kinds of rebates and exemptions. Tax rates are different for Indian companies and foreign companies. Certain types of companies (e.g. export houses) are given tax exemptions and tax holidays.

Taxes on Wealth and Capital : Taxes which are levied on wealth and capital are mainly estate duty, annual tax on wealth and gift tax. Estate duty was first introduced in India in 1953. It was levied on the total property passing to the heirs on the death of a person. From the point of view of proceeds, the estate duty was a minor source of revenue and it was abolished in 1985. An annual tax on wealth was introduced in 1957. It was levied on the wealth such as land, bonds, shares etc. of the people. Certain types of properties such as agricultural land and funds in Provident Account were exempt. Like estate duty this is also a minor source of revenue. With effect from 1.4.1993, wealth tax has been abolished on all assets except certain specified assets such as residential houses, farm houses, urban land, jewellery, bullion, motor car etc. A gift tax was first introduced in 1958 and was leviable on all donations to recognised charitable institutions, gifts to women dependents and gifts to wife.

Gift tax was abolished in 1998. Gift tax was partially reintroduced in April 2005. Gifts received from any person or persons, if the aggregate value exceeds Rs.50000, have been made taxable under the head “Income from other sources”. Certain exemptions have, however, been given. Now (with effect from 1.10.09) even movable and immovable property given as gift would attract tax if its value exceeds Rs 50000.

4.2.1 Indirect Taxes: The main indirect taxes levied in India are custom duties, excise duties, sales tax and service tax.

Custom Duties: Custom duties are levied on exports and imports. From the point of view of revenue, the importance of export duty is limited. Import duties are generally levied on the basis of ad valorem which means they are determined as a percentage of the price of the commodity. On some commodities, specific import duties i.e, per unit taxes on imports are levied. In pre-tax reform period, India had become a country with one of the highest levels of custom tariffs in the world. As a part of rationalisation measures carried out since 1991, the custom duty structure has been pruned.

In the first half of 2008-09 fiscal, prices of certain commodities like crude oil, steel and food etc. shot up world wide. This affected their domestic prices and demand. Consequently, as an anti-inflationary measure, custom duties on many commodities were reduced.

Subsequently, in the aftermath of the impact of global financial meltdown since September 2008, there was a sharp decline in international commodity prices and some of the duty cuts were, therefore, reversed. But since the growth momentum of the economy was slowing down in the second half of the 2008-09, fiscal stimuli in the form of certain custom duties cut and exceptions were also given.

Excise Duties : An excise duty is levied on production and has absolutely no connection with its actual sale. Excise duties are levied by the central Government in a number of forms. Over the years, number of rate categories has been reduced and number of exemptions notifications have also been brought down.

Taxation on inputs, such as raw materials, components and other intermediaries has a number of limitations. It very often distorts the production structure, results in cascading of taxes (i.e. compounding of tax liability) and does not allow correct assessment of the tax incidence. In order to remove these defects, the government introduced Modified Value Added Tax (MODVAT) in 1986-87. Value added is the difference between a firm's revenues and its payments to other firms. It is the value difference between sales and purchased items.

MODVAT was different from VAT. VAT covers the entire value of inputs where as under MODVAT credit was given in respect of duty paid inputs only. Under MODVAT a manufacturer got full reimbursement of excise duty paid on the raw materials or components. This system prevented payments of duties on earlier duties paid. However, MODVAT suffered from many shortcomings. The most important being, the existence of a number of rates on output and inputs leading to disputes relating to classification of both the output and inputs.

In order to combat the problem, the Budget 2000-01 introduced the Central Value-Added Tax [CENVAT]. To attract CENVAT, there must be a process amounting to manufacture/ production and outcome should be excisable goods. The goods should be made in India to attract CENVAT. It consists only one basic excise duty of 8 per cent and some special excise duties. The basic rate of 8 percent is applicable to all the excisable commodities. Special excise duty is in addition to CENVAT. It is leviable on a few mentioned goods. The basic excise paid on excisable goods can be deducted from the excise collected on the output so that only tax on value added is paid.

The CENVAT is simple. It will result in transparency in the system of union excise duty. The earlier system of physically checking of goods can now be replaced by an account based systems. Besides, it reduces cascading effect of input taxation. But the system suffers from certain shortcomings such as existence of some cumbersome procedures, inadequate coverage of CENVAT, scope of tax-evasion and so on.

Sales Tax : Sales tax is a tax on business transactions and thus it differs from excise duty in certain respects. In India, many commodities are not covered by sales tax. Sales tax is more in the case of luxury items and less or almost nil in the case of necessities. Under sales tax, the registered trading concerns are required to pay the sales tax to the government. These registered concerns shift the burden of sales tax to the customers. Sales tax regime suffers from many problems, main being, cascading effect,lack of transparency, narrow base, different procedures followed by different states and so on.

In India, sales tax was in two forms – state sales tax and central sales tax. State sale tax (i.e. tax on transactions within a state) is being replaced by Value Added Tax in all states. Central sales tax is inter-state sales tax. This tax is non-rebatable tax and is incongruent with the system of VAT. Therefore, it is being phased out in stages. At present it is 2 per cent. By the financial year 2010-11, it will be completely phased out. 

VAT : Value Added Tax (VAT) is a multistage sales tax with credit for taxes paid on business purchases. One of the major benefits of VAT over sales tax is that the former is non-cascading. One of the important components of tax reforms initiated since liberalization relate to introducing state-level value added tax (VAT). The VAT is a multi-point destination based system of taxation, with tax being levied on value addition at each stage of transaction in the production/distributional chain. If for example, inputs worth Rs. 1,00,000/- are purchased and sales are worth Rs. 2,00,000/- in a month, and input tax rate and output tax rate are 4% and 10% respectively, then input tax credit and calculation of VAT will be as shown below:

(a) Input purchased : Rs. 1,00,000.
(b) Output sold : Rs. 2,00,000.
(c) Input tax paid : Rs. 4,000.
(d) Output tax payable : Rs. 20,000.
(e) VAT payable after
set-off input tax credit : Rs. 16,000.
[(d) - (c)]
The following are the benefits of VAT:

• A set off will be given for input tax as well as tax paid on previous purchases.
• Other taxes such as turnover tax, surcharge etc. will be abolished.
• Overall tax burden will be rationalised.
• Price will in general fall.
• There will be higher revenue growth.
• The zero rating of exports would increase the competitiveness of Indian exports.
• There is a provision of self-assessment.
• There will be more transparency.

VAT was introduced in 1999 and was implemented in April, 2005 in some states. At present 33 states/union territories have implemented VAT. The tax revenue of the VAT implementing states/union territories has registered a growth of more than 20 per cent per annum since 2006-07.

Service Tax : Service tax is a form of indirect tax imposed on specified services called taxable services. Introduced in the year 1994-95, service tax network has expanded to cover more than 100 services over the years.

The rate of service tax was revised from 5 per cent in 2002-03 to 12 per cent in 2008-09. However, with effect from 24.02.09 it has been reduced to 10 per cent.

4.2.2 Features of Tax Structure in India : Following are the main features of tax structure of India :-

(i) Tax revenues (on account of the centre, state and union territories) form about 20 per cent (2008-09) of the total national income of India. This was only 6.7 per cent in 1950-51 and 11 per cent in 1960-61. Considering the fact that India is a low income economy, the tax burden is quite high. Among the Third World countries, India is one of the highest taxed countries.

(ii) Over the last 57 tax revenue collected both by the Central and State governments has increased many folds from Rs. 460 crore in 1951-52 to more than Rs. 12,00,000 crore in 2008-09.

(iii) The ratio of direct to indirect taxes which was 40:60 in 1950-51 declined to 20:80 in 1990- 91. Thus there has been an increasing reliance on indirect taxes which is not good since they fuel inflationary trends in the country. But since 1990-91, in wake of rationalisation, the proportion of direct taxes has been on rise, whereas that of indirect taxes on the decline. The share of direct taxes in the gross tax revenue (Centre and States combined) was 40 per cent in 2008-09 while that of indirect taxes declined to 60%.

(iv) The population of the economy is more than 115 crore. But only 2.5 per cent of the population is liable to pay income tax in India. Thus Indian tax structure relies on a very narrow population base.

(v) The total tax revenue is highly insufficient to meet the expenditure requirements of the economy. Over time there has been an increasing reliance to internal and external debts.

(vi) The structure of taxes in India has under gone changes. Earlier income tax and corporate tax were important sources of the union revenue. Then excise duties became important. Similarly, land revenues were important source of state revenue. Then sale tax became more important. With the onset of nineties, the relative importance of different taxes has been undergoing changes once again; the importance of personal income tax and corporate tax has been on the rise, whereas that of customs and excise duty on the decline, although Union excise duties continue to be the one of the largest source of tax revenue.

(vii) In India, the direct taxes are progressive, indirect taxes are differential in nature. In other words, direct tax rates increase with increase in income and indirect tax rates are higher for luxury items and lower for necessities.

(viii)The agriculture income is exempt from the income-tax.

4.2.3 Evaluation of the Indian tax system : Although direct taxes are progressive there is a differential rate schedule for indirect taxes. With the increase in national income, the tax yields in general and from direct taxes in particular have not increased at a rate high enough to show a high degree of income elasticity. Direct taxes were 2.1per cent of the GDP in 1950-51. It has increased to around 6.5 per cent in 2008-09.

Indian Tax system largely depends on urban incomes and leaves out almost completely agricultural incomes from the purview of direct taxes. India's tax system has a much reduced scope of manoeuvrability in the field of personal taxation. Thus, while national income rises, with about one-fifth of it originating in the agricultural sector, the tax system is not able to tap fully the rising income. The indirect tax system too is characterised by inelasticity.

Both the coverage and the rate schedule have been modified from time to time so that the tax system plays a truly functional role for economic growth, stability and social justice. It is to be noted that while the service sector accounts for more than 57 per cent of GDP, service tax contributes just 10.4 per cent towards tax revenues and 1.2 per cent towards GDP.

In respect of canon of convenience, several, measures have been taken such as self assessment, advance payment, deduction of tax at source, assessment on the basis of returns submitted, etc. However, changes in tax laws in quick succession disturb long-term business decisionmaking. Indirect taxes, although considered to be regressive, are quite convenient from the collection point of view.

Simplification of tax system has also been attempted. Income tax returns have been simplified and made handy. The Booth Lingam Committee and Chelliah Committee recommended simplification and rationalisation of tax system in India. The proposed Direct Taxes Code also aims at simplification of tax laws.

The cost of tax collection has increased over the years. It has increased from Rs. 543 cores in 1990-91 (Central Government) to more than 3,700 crore in 2007-08. However, it is also noticed that the cost of tax collection for the Income Tax Department is the lowest in the world at the rate of 60 paise for every Rs 100 collected as a tax. Evasion and tax avoidance are reported to be very high. It has been estimated that black money is generated at the rate of 50 per cent of the country's' GDP. Because of this, the black money accumulation is of considerable magnitude. It is growing every year. The unaccounted funds are invested into business through diverse means and add further to the existing funds of black money. A part of it is squandered and wasted lavishly on social functions and on anti- social activities. Besides, the Indian tax system is also accused of (i) discouraging employment (ii) distorting prices (iii) and adversely affecting savings.

SUMMARY

In order to carry out its functions properly every State needs funds. An important way of raising funds is levying taxes. Taxes could be direct and indirect. Direct taxes are taxes which are not shifted i.e., the incidence of which falls on persons that pay them to the government. Examples of direct taxes are income tax, wealth tax. Where the burden is shifted through a change in price, the taxes are indirect. Examples of indirect taxes are service tax, custom duty, excise duty, VAT etc.

A tax system could be proportional (falling on all the incomes at the same rate), regressive (falling on higher incomes at a proportionately lower rate) or progressive rising proportionality with rise in income. Direct taxes are progressive but indirect taxes are generally regressive in nature. An important technique adopted for taxation in India was MODVAT i.e., Modified Value Added Tax. Value Added Tax is the tax to be paid by all sellers of goods and services, on the basis of value added by them. MODVAT was replaced by Central Value Added Tax (CENVAT). Value Added Tax system has been introduced in many States since April 2005.