Impact Of New Tax Code On Financial Markets

1. Study the Impact of proposed
Direct Tax Code on Money
Markets in India
BFMS Term Paper
Submitted to:
Professor P.C. Narayan
Indian Institute of Management, Bangalore
Group 1
Amit Bhalotia 2008007
Dharmesh Gandhi 2008019
Saurabh Jain 2008105
14th November, 2009

2. Table of Contents
1. Scope ........................................................................................................... 3
2. Taxes Framework in India ............................................................................ 3
3. Direct Taxes in India..................................................................................... 4
4. Rationale for introducing new code ............................................................. 5
5. Salient features of proposed Direct tax code and impacts ........................... 6
5.1 Personal Taxation: For individuals, salaried class, etc: .............................. 6
5.2 Change in Saving Behaviour: ..................................................................... 7
5.3 Corporate Taxation: .................................................................................. 7
5.4 Impact of changes in MAT:........................................................................ 8
5.5 Impact on Banking Sector: ........................................................................ 8
6. Estimation Model ........................................................................................ 9
6.1 General Concept: Money Supply ............................................................... 9
6.2 First Level of impact ................................................................................ 10
6.2 Second level of impact for the existing tax base ..................................... 11
6.3 Third Level of Impact: Change in pattern of Savings ............................... 12
6.4 Fourth Level of Impact ............................................................................ 13
7. Conclusions................................................................................................ 14
8. References ................................................................................................. 15
Appendix.......................................................................................................... 16
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3. 1. Scope
In this paper, we have tried to analyze the impact on money markets, due to
various changes in taxation structure under proposed tax code. Since the overall
impact on money market would be dependent on number of factors (apart from
just changed taxation structure), we have limited our scope to estimate the
changes in money supply. We have attempted to create mathematical model to
estimate the change as a function of disposal income.
2. Taxes Framework in India
The existing direct tax framework is decades old (Income Tax Act, 1961); and
has been subjected to numerous amendments from time to time, which has
further increased the complexities in taxation structure and understanding.
In August 2009, Finance Ministry released the draft of Direct Tax Code (DTC) that
seeks to revamp and simplify the Direct Tax laws & its administration. The
proposed code envisages meaningful reduction in tax rates while simultaneously
being revenue neutral for the government. It aims to achieve this by increasing
the tax base and rationalising the countless tax exemptions prevalent under
current law. The proposed changes are expected to be beneficial for number of
sectors & companies, would impact individual savings and money markets.
Coupled with the introduction of Goods & Services Tax (GST) Bill to revamp the
indirect tax regime, Government of India is overhauling the complete tax
framework and setting the stage for the next phase of growth of Indian Economy.
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4. 3. Direct Taxes in India
Contribution of the direct taxes to GDP in India, has been increased steadily,
which is good signal. Government focus has been shifted towards realizing direct
taxes and ensuring enhanced compliance. The direct taxes contribution to GDP
has increased from 4.2% in 2004-05 to 6.9% in 2008-09; whereas indirect taxes
contribution to GDP has grown marginally from 5.4% in 2004-2005 to 6.0% in
2008-09.1
Fig: TAX to GDP Ratio
1
Source: Economic Survey 2008-09, KPMG Analysis
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5. 4. Rationale for introducing new code
Rationale behind introducing the direct tax code was primarily to revamp and
simplify the Direct Tax law & its administration. The proposed code envisages
meaningful reduction in tax rates while simultaneously being revenue neutral for
the government. It aims to achieve this by increasing the tax base and
rationalising the countless tax incentives prevalent under current law.
Some of the key points that are expected to be addressed by introduction of new
Tax Code are:
Income Tax Act, 1961 Direct Taxes Code Bill, 2009
• Numerous amendments - perplexing
for the tax payers.
• Simple and easy to comprehend.
• Increased cost of compliance and
• Reduction in corporate tax rates –
administration.
in line with global trends.
• Interpretation issues leading to
• Proposals to increase the tax base.
litigation and controversies.
• Attempt to minimize litigation / tax
• Ambiguities causing conflicting
controversies.
judgments on same issues by the
courts.
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6. 5. Salient features of proposed Direct tax code and impacts
5.1 Personal Taxation: For individuals, salaried class, etc:
The Tax code proposes a significant increase in the tax slabs for personal income
tax which, if implemented, will result in a meaningful increase in disposable
income, especially benefiting FMCG and other domestic consumption companies.
The increase in tax slabs is quite substantial in view of country's per capita
income distribution, and would lead to more money availability in money markets
& banks, depending on the various factors as discussed later in the paper.
However, the code proposes to abolish the Securities Transaction Tax (STT) by
removing the distinction between long-term & short-term capital gain, effectively
taxing all capital gains at the applicable marginal tax rate. At present, the long-
term capital gains tax is Nil on equity transactions on which STT is paid and 20%
on all other assets, while the short-term capital gains tax rate is 10% on equity
transactions on which STT is paid and 30% on other assets. This increase in
capital gain tax rates is expected to partially offset the benefits from reduction in
tax rates.
Other amendments at the personal taxation front include:
• Limit for deductions of savings for individuals and salaried class will go up to
Rs three lakh from Rs one lakh (under Sec. 80C of the existing IT Act).
• The DTC proposes to introduce EET (exempt, exempt, tax) method of taxation
of savings compared to existing EEE system.
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7. • Surcharge and cess on education will be removed and the peak income tax
rate will be kept at 30 per cent.
• Several tax exemptions under Section 80 C of existing IT Act – like,
instalments paid on Housing Loans, contributions to ULIPs and ELSS of mutual
funds, Bank notified fixed deposits of 5-years or more, interest accrued on
NSC – will be removed.
• Interest on Housing Loan will not be allowed as deduction.
• An individual’s gross salary would include all perquisites such as rent-free
accommodation, medical reimbursements, leave travel concession, etc. and
all these will be taxed according to their respective tax slabs.
5.2 Change in Saving Behaviour:
Proposed increase in tax deduction limit on savings from Rs one lakh at to Rs
three lakh, would likely to incentivize the user for saving. However, it would be
offset in some sense by the introduction of EET norm, i.e. investments in tax
savings instruments (PPF, Insurance, etc.) will only lead to a postponement of tax
liability rather than an outright exemption as applicable at present.
5.3 Corporate Taxation:
The key amendments in the taxation structure for corporate include:
• Peak Corporation tax will be reduced from 34 per cent to 25 per cent while
surcharge and cess on education removed.
• MAT will be changed radically; new MAT rate will be two per cent (0.25 per
cent for banking companies) of gross fixed assets replacing the existing
system of 15 per cent MAT on book profits.
• MAT will be final tax and it will not be allowed to be carried forward for
claiming tax credit in subsequent years.
• Foreign companies will have to pay a branch profit of 15 per cent.
• DTC provisions will override the provisions of tax treaties, for example,
Double Taxation Avoidance Agreement with Mauritius.
• All tax exemptions will be phased out over a specified timescale.
• All area-based exemptions will be removed for corporate.
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8. 5.4 Impact of changes in MAT:
The new system, MAT will be paid at a specified percentage of Gross assets of a
company (broadly equates to capital employed, although it is unclear whether Net
or Gross Current Assets will be considered for computation). Although intended to
widen the tax base by reducing tax evasion, the new MAT proposals appear
burdensome on several counts:
• Companies suffering genuine losses or sub-normal RoCE due to initial
gestation period or cyclical downturn would also have to pay MAT at 2% of
gross assets.
• Since service sector (contributing to almost 54% of GDP) is not capital-
intensive, it may not be impacted under MAT; but this may not be so for
capital-intensive infrastructure companies which have long gestation
periods and may be required to pay MAT even in the initial years of low or
virtually no profits.
5.5 Impact on Banking Sector:
• Change in MAT may not impact the giants, but it will affect the small-cap
& mid-cap banks like DCB, UCO etc).
• Changes would allow banks to have greater NPA provisions
• Reduced tax rates will definitely provide a big relief to banks.
• Imposition of tax at the time of withdrawal is likely to reduce
attractiveness of tax saving instruments (PPF, ULIPs, ELSS, etc), and will
alter the investment decisions.
• Banks may not be hit very much but mortgage companies like HDFC and
LIC Housing Finance would receive lesser interest income.
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9. 6. Estimation Model
We have tried to analyze the increase in money supply
Tax Collected = Income Tax + Corporate Tax +Professional Tax + Capital Gains Tax
+ Dividend Tax
6.1 General Concept: Money Supply
M1: currency with public + checkable deposits with the bank (includes only short
term demand deposits)
M2: M1 + post office saving deposits + short term bank deposits
M3: M2 + other time deposits (broad money supply)
M = C + D : Money Supply
Where,
R : Reserves
D: Deposits
C: Currency with public
M: Money Supply
B: Monetary Base
m : Money multiplier
Monetary base, B = C + R
Reserve-deposit ratio, rr = R/D ;
Currency-deposit ratio, cr = C/D
( + )
=
( + )
M=mB
( + 1)
m= ( + )
Let’s first focus on 3 levels of impact because of direct tax code on individuals and
hence on money supply
= − ( )
Where, x= Income and Ei is i-th exemption/deduction; here the assumption can be
that if an exemption is available and is of benefit, it will be taken. Example: sec 80C
benefit, home loan interest benefit
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10. 6.2 First Level of impact
There are people who do not declare their taxes as the tax might not be deducted at
source. If the cost of compliance is very low and the cost of non-compliance
relatively high then the person might comply. Cost of compliance and non –
compliance is dependent on income tax structure, penalty clauses, investment
opportunities available with white (after-tax) money and enforcement procedures
available. Let’s try to model each of them as cost or benefit. Whether a person
complies will depend on the income, past history of compliance, tax paid if he
complies, cost of peace of mind, etc
It will be good to estimate a cost or a utility based model of compliance to find the
probability of compliance.
Let cost of compliance be C1 i.e. incremental outflow because of tax outgo. Let cost
of non-compliance be C2 (this can be money equivalent of peace of mind +
probability of penalty+ foregone investment opportunities).
Compliance if C1 < C2 i.e. C1 should be significantly lower than C2 for increased
compliance.
C1=C1(x) ; incremental outflow because of compliance
C2=C2(x) ; money equivalent of peace of mind, penalty, foregone investment
opportunity
X=income
Assuming the population income distributed as a well behaved continuous function,
need to find out for what ranges of x is C1(x) < C2(x) . The area under the curve
would give the proportion of compliance. Then add an error to each of these terms to
make the model richer and more realistic as these costs might not be the only thing
affecting compliance.
( )+ < ( )+
this simply means we look at the probability of C1 being significantly less than C2 for
a given value of x
ε1 - ε2 ∼ f ; probability distribution density function
Pr(x)= Probability of compliance at a given income x=∫-αc2-c1 f(y) dy
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11. Let I(x) = Number of people with Income x.
Tax (x) = Tax at income x
S(x)= Proportion of disposable income in bank.
So additional money in the system= ( ) ( ) 1− ( ) ( )
If m= Money multiplier (=5.3-5.5 currently in Índia, from RBI site
, site)
Increase in Money supply because of better tax compliance
= ( ) ( ) 1− ( ) ( )
For our purpose we can consider only that portion of population that evade taxes
under the existing tax code.
So Tax evaders: x s.t. TaxApplicable(x) 0 > ActualTax(x);
Now here the important unknown is the probability distribution f(y) . Since it is a
distribution
discrete choice we can probably attempt a close form solution using binary logit
instead of binary probit.
Here the choices are to pay tax or not to pay tax. We have currently put only income
as a factor. In presence of other factors having an impact which is not insignificant,
other
they can be included.
6.2 Second level of impact for the existing tax base
There shall be an increase in disposable income mainly because of direct tax rate
mainly
decreasing. On an existing tax base this will have an impact depending on taxable
ecreasing.
income.
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12. Again let x = income; I(x)= increase in disposable income; the relationship given by the
above graph;
Σi Ii(x) = total increase in monetary base i.e. B
There may or may not be a change in "m" depending on cr and rr defined above.
6.3 Third Level of Impact: Change in pattern of Savings
Another level of impact is the change in saving pattern which also has an impact of cr
value.
Assume a person generally saves 40% of the income. If the person knows that when he
withdraws money from PPF or EPF, etc it would change the pattern of saving.
He might end up saving lesser for future consumption. One portion goes into increasing
cr which will reduce 'm' .
Let s2(x) be the propensity to save in demand or time deposits with the new tax code
s1(x) = propensity to save with the existing tax code; this is dependent mainly on income;
also with culture of course but we'll ignore that for the time being.
Total shift: Σi [si2(x)-si1(x)] Ii(x) = Reduction in C or increase in R
Hence money multiplier will go up if savings go up, else it goes down.
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13. 6.4 Fourth Level of Impact
ST Capital Gains Tax rate = LT Capital Gains Tax rate
Let’s model that impact as CGT(STCGR2-STCGR1, LTCGR2-
LTCGR1,DLTCG, DSTCG)
Where, CGT = capital gains tax
STCG = short term capital gain
LTCG = long term capital gain
DLTCG = dividends for LTCG
It’s important to think what’s the impact of this move of capital gains tax on
incentivizing/disincentivizing black money conversion.
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14. 7. Conclusions
The government has stared phasing out the four-and-a-half-decade old Income
Tax Act of 1961 with a new and ‘taxpayer friendly’ Code. The Code is designed to
provide stability to the tax regime and is based on the accepted principles of
taxation and best international practices.
By decreasing the cost of compliance (lower taxes), increasing the cost of non-
compliance (GAAR) and lowering the cost of administration; the DTC will help
widen the tax base in India.
In interaction with the industry and tax experts, the Finance Minister has
identified nine areas for re-examination, including the minimum alternative tax
(MAT), capital gains tax, double taxation avoidance agreement, general anti-
avoidance rule, taxation of charitable organisations & foreign companies in India,
taxing investments at the withdrawal stage (that is EET), taxation of income from
house property in case of self-occupied property by an individual; and taxation in
case of salaried class employees.
The estimation model that we have come up with can be enriched further using
other behavioural aspects of people. This is just the impact of individual related
tax aspects. To get the complete picture we need to similarly model all other
features of the new tax code and the difference from the old tax code.
A theoretical model was attempted mainly because of the problems we faced in
finding the statistics like income distribution, tax avoidance rate, behavioural
aspects, penalty clauses,etc. However the motive has been to show that they can
be modelled and their impact can be calculated using appropriate assumptions
and approximations.
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15. 8. References
1. RBI website (rbi.org)
2. Finance Ministry (finmin.nic.in)
3. KPMG report
4. Business Line reports
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16. Appendix
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