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Effective Tax Rates for Indian Companies Post-liberalisation

Pradeep Kumar Meel (pkmeel@gmail.com) and Seema Sharma are with the Indian Institute of Technology, New Delhi.

This article studies the effective tax rate for Indian companies from 1990 to 2010, covering the period just before liberalisation of the economy and tax reforms in 1991 and later. It examines the effect of a declining corporate tax rate on the gap between book profit and taxable profit. A narrowing gap between statutory tax rates and effective tax rates after liberalisation indicates increased voluntary compliance.

Corporate tax rates vary a great deal across countries. Approaches to it are also different, as some Organisation for Economic Co-operation and Development (OECD) members such as the United States (US), Israel, and Ireland tax their resident corporations on worldwide income while a majority of others, including the United Kingdom (UK), France, Italy, and Germany, follow a territorial model and do not tax the foreign income of their corporations. India follows the worldwide income taxation model. Over the years, corporate tax rates have been significantly reduced in India and abroad. After the balance of payment crisis in 1990, the Indian government reduced tax rates across the board. The theory that lower rates would increase the tax base to offset any decrease in the total collection due to decreased tax rates gained acceptance. The theory has been vindicated by trends in tax collection over the years.

Figure 1 (p 22) depicts corporate tax rate (including surcharge and cess) plotted over the years. As can be seen from the figure, it has been steadily declining.

The ratio of corporate tax revenue to gross domestic product (GDP) in India, computed using Reserve Bank of India (RBI) data, is plotted over the years in Figure 2 (p 22). Here, the corporate tax revenue to GDP ratio has been increasing over the years. It stood at a mere 1% in the 1970s, but has increased to 4% in recent years.

Corporate income tax rates have been lowered substantially over the last 25 years by many OECD countries. The variation in both corporate tax rates and revenues is huge among its member nations. Some, such as the US, have witnessed a fall in corporate revenues vis-à-vis GDP but the average OECD country has had a substantial increase in the share of corporate tax revenues in GDP. Indian corporate tax revenues have witnessed a fourfold increase in two decades, from 1% of GDP in the early 1990s to 4% of GDP.

The corporate tax rate versus corporate tax revenue debate poses certain key policy issues for the government. First, governments are interested in knowing what factors drive their corporate income tax revenues. The information affects the tax rate choice, the scope of the tax base, and the treatment desired for international income. Further, there is tax competition among countries. In this era of globalised economies, understanding the international forces affecting the collection of revenue is essential. Multinational firms respond to tax arbitrage by shifting headquarters to low-tax countries or by shifting profits to them.

Significant increases in trade and foreign direct investment have increased capital mobility, which has led to increased rewards from tax competition. The benefits and costs of lower or higher levels of taxation may be much greater today than a few decades ago. Increased capital mobility due to higher rates may lead to declining corporate revenues. In theory, multinational firms can move activities between localities, and it is increasingly seen that revenues decline if there is a steep rate gradient among nations. In a world devoid of such mobility, countries may keep the capital “captive” and reap healthy revenues even with high rates, but it is not possible in today’s interconnected financial world.

Differences in accounting rules for book purposes (book profit) and tax reporting purposes (taxable profit) can lead to a variance in the profit disclosed to shareholders and the profit reported to tax authorities. A study of the difference between the two is useful for the tax administration in determining compliance, and also to assist investors/shareholders in assessing the quality of earnings. The effective tax rate (ETR) is defined as the ratio of taxes paid to book profits, and this is different from the statutory tax rate (imposed by the government).

There has been a debate in the US over the last 50 years on the potential benefits and costs of increased conformity between reported earnings and taxable income. Proponents of conformity suggest that increased book-tax conformity will simultaneously reduce aggressive financial reporting and abusive corporate tax sheltering, which will result in improved tax compliance and better earnings quality (Desai 2005; Whitkar 2006; Joint Committee on Taxation 2006). Opponents argue that the information required by tax authorities is substantially different from that sought by financial statement users. Since Parliament is likely to control rule-making, rather than an independent body like the Institute of Chartered Accountants of India (ICAI) prescribing accounting standards, the increased book-tax conformity will reduce earnings quality.

The opponents believe that the tax system is designed to meet the government’s goals of increasing tax revenues and providing industry-specific or area-specific incentives. Accounting standards are intended to reduce information asymmetries and designed to allow managers flexibility in conveying information to the market. In a nutshell, though there are genuine reasons for the divergence of the two profits, a study of the ratio of the two over a span of time indicates a trend in the tax planning activities of companies. The introduction of provisions such as the minimum alternate tax (MAT) since 1997–98 has been able to discipline so-called “zero tax companies” who would show huge profits to their shareholders while paying negligible tax to the government.

Literature Review

Discussions on book-tax conformity lead to a discussion on the quality of accounting earnings and the amount of information conveyed by accounting earnings. Proponents generally assert that increasing book-tax conformity simultaneously provides incentives for managers to reduce tax avoidance and to report accounting earnings less aggressively, which will result in improved earnings quality (Yin 2001; Desai 2005; Joint Committee on Taxation 2006; Whitaker 2006). Opponents of increased book-tax conformity argue that high conformity will result in lower quality (or less informative) accounting earnings (Hanlon and Shevlin 2005; Hanlon 2005; Plesko 2006; Shackelford 2006)

Theories of tax competition based on capital mobility and fixed labour markets go on to suggest that tax rates on capital should decline and that lower capital (corporate) taxes would be preferred by open and integrated economies. Hansson and Olofsdotter (2004) conclude, “The results of previous studies seem inconsistent, and provide only weak empirical support for the predictions of the tax competition theory.” Slemrod (2004) notes,

There is no consensus in the political science literature that openness, liberalisation, or globalisation has led to reduced taxation of capital income, including use of the corporate income tax, although lower corporate taxes were sometimes pursued as a policy package with financial liberalisation.

Results from both suggest that tax competition is a reason for reducing corporate tax rates. Swank (1998) finds corporate income tax rates positively correlated to capital mobility in OECD countries.

Slemrod (2004) observes that in certain specifications of his model, in certain years, a greater degree of openness predicted lower tax rates. Some evidence of a Laffer effect, although not explicitly acknowledged by Slemrod, is apparent as he writes,

While a policy of openness may contribute to driving down the rate of taxation per unit of investment, bigger, more globalised economies attract a higher base for corporate taxation, and, therefore, can collect more revenue from taxing corporate income.

Auerbach and Poterba (1988) consider the sources of the decline in US corporate income tax revenues over the period 1959 to 1985; and Douglas (1990) does a similar analysis for Canada over 1960 to 1985. Both papers decompose the tax revenue share into the tax rate and the profit rate, as Taxes/Assets = Taxes/Profits * Profits/Assets. Both studies conclude that it is declining profitability that explains the bulk of the reduction in corporate income tax revenues, rather than declining tax rates.

Devereux et al (2004) consider UK corporate tax revenues between 1980 and 2004, focusing on the combination of reductions in corporate statutory tax rates and increases in corporate revenue. After a careful examination of the data, they conclude that this puzzle is explained partially as a result of measures that increased the breadth of the corporate income tax base.

Mody et al (2011) examine the sources of corporate profits in India. They argue that till the 2000s, the Indian growth story is consistent with a competitive and dynamic business sector, despite the continued dominance of business houses and public sector firms in sales and assets.

Recent works that explore the specific issue of corporate income tax and the Laffer curve are Clausing (2007) and Brill and Hassett (2007). Clausing (2007) finds a parabolic relationship between tax rates and tax revenue among OECD nations, consistent with the Laffer curve interpretation. Brill and Hassett (2007) extend her work to find time variation in the revenue maximising corporate income tax rate from 1980 to 2005. They conclude that the revenue maximising corporate tax rate was about 34% in the late 1980s, and that it has steadily declined to about 26% in recent years.

Methodology

Corporate Tax Revenue as a ratio of Corporate Asset Base is considered as function of tax rate (both the tax rate and its square), Taxable Profits/Book Profits and corporate profitability (Book Profits/Asset Base).

Corporate Tax Revenue/ Total Assets = Corporate Tax Revenue/ Corporate Profits {Tax Rate} X Taxable Profits/ Book Profits X Book Profits/ Total Assets

— Equation 1

As per the literature, corporate tax rate and corporate profitability (Book Profits/Total Assets) have a positive direction of influence (higher tax rate should increase revenue, and corporate profitability contributes directly to a larger tax base) whereas the square of tax rate has a negative influence (accounts for a likely non-linear relationship between tax rates and revenues).

Corporate Tax Revenue/Assett1Tax Ratet2Tax Ratet23Corporate Profitabilityt

where t is the year

Data

Two data sources have been used. The first is the time series data of GDP (at current prices) and corporate tax revenues obtained from the RBI Handbook of Statistics on the Indian Economy with 40 observations (1972 to 2010). The second source is the Prowess database of CMIE containing 21 observations from the year 1990 to 2010. The total number of companies filing returns with the income tax department was reported to be 3,67,884 in 2009–10, with total corporate tax revenue collection at ₹2,44,724 crore. The Prowess database of 2009–10 has the data of 17,017 companies, with total corporate tax revenue as ₹1,50,474 crore. Though the percentage of total number of companies in the Prowess database comes to a meagre 4.6%, the share of corporate tax revenue collected was nearly 50% of corporate tax collection over the years. Therefore, the analysis based on the CMIE data can safely be extrapolated for the working corporate sector of the country for the purpose of our study.

Since the data for Tax Profit/Book Profit as described in Equation 1 is not independently available, we leave it, considering only the two independent variables—tax rate (and its square) and corporate profitability (Book Profit/Total Assets) for our regression analysis.

Analysis and Results

The ratio of corporate tax revenue to GDP is plotted against the corporate tax rate in Figure 3 (p 23). There is a sudden surge of tax revenues as a ratio of GDP when the tax rate approaches 33%, an internationally competitive tax rate, which implies Indian companies are not too prone to parking their profits abroad.

In addition to the countrywide information analysed above, a further analysis is performed on the data set of companies available in Prowess. Figure 4 (p 23) plots the statutory tax rate (including surcharge and cess) and ETR (defined as taxes paid as a ratio of Book Profit) for the companies whose data is available in the Prowess database from 1990 to 2010.

Figure 5 (p 23) depicts corporate tax/total assets plotted against the tax rates for companies with data available in the Prowess database from 1990 to 2010. The ratio helps us in negating the influence of a varying number of companies in the data set over the 20-year period. As seen in the figure, there is a sudden surge of tax revenues as a ratio of GDP when the tax rate approaches 33%. This is very similar to the scatter plot obtained using RBI data (Figure 3).

Using the model defined for Equation 1 and running a regression analysis with the help of Stata 11 software, the results for the coefficients are as under.

Specification 1 is run using tax rate as the only independent variable. Specification 2 is run using another variable—corporate profitability—as the independent variable, the dependent variable being the corporate tax revenue as a percentage of total assets of the companies studied.

As against the result of Clausing (2007), the coefficient of tax rate has become negative, whereas the coefficient of tax rate square has become positive. This is because our data set, compared to Clausing’s, does not have tax rates below the optimum to have a full Laffer curve. The data set available to us provides a picture of only one half of the Laffer curve, with signs of coefficients swapped for tax rate and its square.

The difference in signs still supports the underlying concept of the Laffer curve. The prime reason for this can be seen in Figure 5, which has a sudden dip in revenues at a tax rate more than 33%. As we know from other sources, the Indian corporate sector witnessed a sudden surge of revenues from 2000 to 2010 when the economy saw a dot-com and a real estate boom. The underlying theme of the Laffer curve—increasing tax revenues with decreasing tax rates—is clearly evident in the scatter plot and the signs of coefficients of tax rate and tax rate square obtained through regression.

Policy Implications

Book profits are the profits shown in the return of income filed with the registrar of companies and also with stock exchanges in the case of listed companies, whereas taxable profit is the profit filed with the income tax department, on which taxes are paid. A low taxable profit to book profit indicates a high degree of tax planning using various deductions and exemptions provided under various provisions of the Income Tax Act.

The biggest proof of tax planning by corporates can be seen in Figure 4, which shows the coefficient of tax planning falling and the gap between statutory tax rate and effective tax rate narrowing over the years. Figure 4 shows the effective tax rate improved from 20% in 1990 to around 25% in 2010, while the statutory tax rate decreased from 60% to 33% (including surcharge and cess) during the same period.

This article supports the underlying theme of reducing tax rates while opening up the economy, as India did in 1991. Revenues did not immediately pick up after liberalisation. They actually dipped and growth continued to remain flat till 2000, when the real positive effects of reducing rates became evident. It is worth mentioning that the corporate tax rate proposed in the new Direct Tax Code was 25% consistent with the Brill and Hassett observation that the corporate tax rate would fall with increased integration. Continuing with the prevalent view worldwide, India’s union budget for 2015 announced a gradual reduction in the corporate tax rate to a target rate of 25%.

References

Auerbach, A J and J M Poterba (1988): “Why Have Corporate Tax Revenues Declined?,” Economic Effects of the Government Budget, E Helpman et al (eds), Cambridge: MIT Press, pp 33–49.

Brill, Alex and K A Hassett (2007): “Revenue-maximising Corporate Income Taxes: The Laffer Curve in OECD Countries,” AEI.

Clausing, K A (2007): “Corporate Tax Revenues in OECD Countries,” International Tax and Public Finance, 14:115–33.

Desai, M (2005): “The Degradation of Reported Corporate Profits,” Journal of Economic Perspectives, 19, pp 171–93.

Devereux, M P, R Griffith and A Klemm (2004): “Why Has UK Corporation Tax Raised So Much Of Revenue?,” Fiscal Studies, 25(4), pp 367–88.

Douglas, A V (1990): “Changes in Corporate Tax Revenue,” Canadian Tax Journal, pp 66–81.

Hanlon, M (2005): “The Persistence and Pricing of Earnings, Accruals, and Cash Flows When Firms Have Large Book-Tax Differences,” Accounting Review, Vol 80, No 1, pp 137–66.

Hanlon, M and T Shevlin (2005): “Book Tax Conformity For Corporate Income: An Introduction to the Issues,” Tax Policy and the Economy, 19, pp 101–34.

Hansson, A and K Olofsdotter (2004): “Integration and Tax Competition: An Empirical Study of OECD Countries,” paper presented at IIPF, Milano, pp 1–31.

Joint Committee on Taxation (2006): “Present Law and Background Relating to Corporate Tax Reform: Issues of Conforming Book and Tax Income and Capital Cost Recovery.”

Mody, A, A Nath and M Walton (2011): “Sources of Corporate Profits in India–Business Dynamism or Advantages of Entrenchment?,” IMF.

Plesko, G (2006): “Testimony before the Committee on Finance,” US Senate, 13 June.

Shackelford, D (2006): “Testimony before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means,” 9 May.

Slemrod, J (2004): “Are Corporate Tax Rates, or Countries, Converging?,” Journal of Public Economics, 88, pp 1169–86.

Swank (1998): “Funding the Welfare State: Globalization and the Taxation of Business in Advanced Market Economies,” Political Studies, 46(4), pp 671–92.

Whitaker, C (2006): How to Build a Bridge: Eliminating the Book-Tax Gap, Tax Lawyer, 59.

Yin, G (2001): “Getting Serious About Corporate Tax Shelters: Taking a Lesson from History,” SMU Law Review, 54, pp 209–37.

Updated On : 28th Jul, 2017

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