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Minhaz Merchant

Minhaz Merchant is the biographer of Rajiv Gandhi and Aditya Birla and author of The New Clash of Civilizations (Rupa, 2014). He is founder of Sterling Newspapers Pvt. Ltd. which was acquired by the Indian Express group

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BW Businessworld

After Demonetisation, Big Bang Budget

Post-demonetisation, the government must focus its resources (manpower and technology) on higher tax slabs to optimise results and make the tax-collection machinery more cost-efficient

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Out of a stock of Rs. 14.95 lakh crore in old currency notes of Rs. 500 and Rs. 1,000 denomination, approximately Rs. 10 lakh crore are expected to be turned into banks by December 30, 2016. A trickle will flow into the Reserve Bank of India (RBI) with a declaration form up to March 31, 2017.

It is estimated that around Rs. 4 lakh crore worth of demonetised notes will end up “dead”. Their holders prefer to write them off rather than open themselves up to scrutiny by the income-tax department.

Consider the fiscal impact of these developments. First, the RBI’s liabilities on its balance sheet will reduce by Rs. 4 lakh crore on account of the dead notes. This allows it two options: one, increase its dividend to the government; and two, help recapitalise stressed banks.

The second consequence of demonetisation will be felt on the fiscal deficit. Depending on their provenance, a portion of the Rs. 10 lakh crore expected to be deposited in banks by December 30, 2016 (and into the RBI by March 31, 2017) will be taxable.

Assuming an average tax rate of 15 per cent across the Rs. 10 lakh corpus (since some of it will not be taxable due to various exemptions), the government will receive a one-time windfall of about Rs. 1.50 lakh crore.

Total personal income tax collection in 2015-16 was just over Rs. 3 lakh crore so this represents a significant increase of 50 per cent over the base.

The key lies in ensuring the tax gains recur every year. Conservative estimates put this at a mere Rs. 50,000 crore a year from old and new assessees. More optimistic estimates place the incremental recurring annual figure at Rs. 1 lakh crore.

Whatever the final number, the fiscal deficit is set to fall. This year’s gains include 45 per cent tax on Rs. 65,250 crore received from the Income Declaration Scheme (IDS), unbudgeted funds from the incomplete 700 MHz telecom spectrum auction, and now the likely Rs. 1.50 lakh crore tax windfall from demonetisation.

All these will help reduce the fiscal deficit to well below 3 per cent of GDP even if the gains are spread over two accounting years. Since banks are flush with cash deposits, the RBI is almost certain to cut interest rates by a significant amount in December. Inflation too will remain soft.

More importantly, it gives finance Minister Arun Jaitley elbow room to go for big bang reforms in the next Union Budget due on February 1, 2017. Both income-tax and long-term capital gains tax rates should be key targets.

A simple, effective personal income tax regime would look like this:

Zero tax up to Rs. 5 lakh net taxable income;

Flat 10 per cent tax on taxable income between Rs. 5 lakh and Rs. 10 lakh. No exemptions;

Flat 20 per cent tax on taxable income above Rs. 10 lakh. No exemptions;

Corporate tax: flat 25 per cent. No exemptions.

Such a simplified low-tax structure would actually increase compliance and revenue in the long term.

Post-demonetisation, the government must focus its resources (manpower and technology) on higher tax slabs to optimise results and make the tax-collection machinery more cost-efficient.

There’s one more tax reform Jaitley can implement in the next Union Budget. Remove long-term capital gains tax on residential premises. The tax garners less than Rs. 100 crore a year. By scrapping it, the housing market, where sentiment and funds have been hit by demonetisation, will receive a fillip. It could also be an election winner.

A caveat here: the last thing the demonetisation exercise – which has cost many innocent people days of trauma and some their very lives – should end up doing is give tax officers excessive discretionary powers. That would hamper India’s rise in the global index of the Ease of Doing Business.

The cure would be worse than the disease.