Warren Buffett’s favourite business book tells us what is wrong with India’s tax system

Vivek Kaul

Business books are soporific. They put me to sleep.
Nonetheless, now and then, one does come across an excellent business book as well. These days I am reading John Brooks’ Business Adventures. The book is a collection of 12 long articles that Brooks wrote for the New Yorker magazine.
In July 2014, Bill Gates wrote a blog titled The Best Business Book I’ve Ever Read. As he put it : “Not long after I first met Warren Buffett back in 1991, I asked him to recommend his favorite book about business. He didn’t miss a beat: “It’s Business Adventures, by John Brooks,” he said. “I’ll send you my copy.” I was intrigued: I had never heard of Business Adventures or John Brooks. Today, more than two decades after Warren lent it to me—and more than four decades after it was first published—Business Adventures remains the best business book I’ve ever read.” This blog by Gates sent the book to the top of the best-sellers lists almost everywhere.
The third chapter of the book is called The Federal Income Tax. Brooks makes several points in the chapter about the income tax system in the United States as it had prevailed in the fifties and sixties. Some of the points I feel are as applicable to the general tax environment in India today as they were in the United States back then.
As Brooks writes in the context of the federal income tax in the United States: “A good deal of the attention given to the income tax is based on the proposition that the tax is neither logical nor equitable. Probably, the broadest and most serious charge is that the law has close to its heart something very much like a lie; that is, it provides for taxing incomes at steeply progressive rates, and then goes on to supply an array of escape hatches so convenient that hardly anyone, no matter how rich, need pay the top rates or anything like them.”
Long story short: The rich were “supposed” to be taxed at a high rate, but at the same time enough loopholes were built into the income tax laws ensuring that they did not pay the highest tax rates in reality.
A similar sort of scenario prevails in India when it comes to the Income Tax Act in particular and taxes in general. Along with the budget every year, the government of India puts out a statement of revenue foregone under the central tax system.
What is the purpose of this system? “The estimates and projections are intended to indicate the potential revenue gain that would be realised by removing exemptions, deductions, weighted deductions and similar measures,” the latest statement of revenue foregone points out.
The deductions, exemptions and other measures lead to a loss of revenue for the government. As can be seen from the accompanying table the revenue foregone for the government during the year 2013-2014 has been estimated to be at Rs 5,72,923.3 crore.

Statement of Revenue Foregone

A simplistic way of looking at it is that the revenue foregone number is greater than the fiscal deficit of the government for 2013-2014, which stood at Rs 5,42,499 crore.
Nevertheless it needs to be pointed out that the statement of revenue foregone is based on certain assumptions. As the statement points out “ The estimates are based on a short-term impact analysis. They are developed assuming that the underlying tax base would not be affected by removal of such measures….The cost of each tax concession is determined separately, assuming that all other tax provisions remain unchanged. Many of the tax concessions do, however, interact with each other. Therefore, the interactive impact of tax incentives could turn out to be different from the revenue foregone calculated by adding up the estimates and projections for each provision.”
So the revenue foregone figure needs to be looked at with these limitations in mind. Having said that, the government of India is losing out on revenue because of the exemptions and deductions. There is no denying that. As can be seen from the above table corporate India is a major beneficiary of the same, like the rich were in the United States, around the time Brooks wrote about the federal income tax.
Getting back to Brooks, he also points out that laws and the regulations were so vast that the critics thought it was an “undemocratic state of affairs, for only the rich can afford the expensive professional advice necessary to minimize their taxes legally”.
This is what is happening in India as well. Companies have an army of chartered accountants and lawyers, working towards legally minimizing taxes, whereas most individual tax payers find it difficult to afford the services of a good chartered accountant who can help them.
Brooks also talks about the favoured treatment of capital gains. This is something that really helps the rich because they are the ones primarily investing in stocks and bonds. In India short term capital gains on equity gets taxed at 15%. There is no long term capital gains tax on equity i.e. if you buy and then sell a share after one year, you don’t have to pay a tax on the capital gains you make when you sell the shares. Equity mutual funds are treated in a similar way.
In case of debt mutual funds, long term capital gains come into the picture if the investment is held for a period of more than three years. Long term capital gains are taxed at either 10% or 20% with indexation, whichever is lower. Indexation allows inflation to be taken into account while calculating the cost of purchase. This brings down the tax significantly.
Now compare this to the common man’s investment—the humble fixed deposit. In this case the interest earned is taxed at the marginal rate of tax. Why is there a favourable treatment for investing in equity? I have often been told that this is because the investor investing in stocks is taking on more risk than the fixed deposit investor, and hence needs to be encouraged through a favourable tax treatment.
This I guess is “bullshit” (pardon my French!) of the highest order perpetuated by those who invest in equity and do not want to pay any tax on it. The amount of risk that an individual wants to take on with investments, is his or her personal preference and should have nothing to do with the prevailing income tax system. Nevertheless that’s the way things stand. Equity gets preferential tax treatment all over the world.
Other than this, the Indian Income Tax Act has a very interesting provision for those taking on a home loan to buy a home. In fact, the Act encourages people to speculate in real estate. There is no restriction on the number of homes against which you can claim a tax deduction on the interest paid on the home loan to fund the property. Only one of these properties needs to categorized as a self-occupied property. On this self-occupied property, an interest of up to Rs 1.5 lakh can be claimed as a tax deduction.
But this limit does not apply to the remaining homes that an individual may choose to buy. Any amount of interest paid on home loans can be claimed as a deduction as long as a “notional rent” is added to the income.
We all know that these days “rents” are relatively low in comparison to the EMIs that need to be paid in order to repay the home loan. Hence, the interest component tends to be massive during the initial years and helps people with two or more homes, claim huge tax deductions.
In a country where a large number cannot afford to buy a home what is the logic in having a regulation like this one?
The Direct Taxes Code, which is supposed to be replace the Income Tax Act, in its original form simplified the income tax system. In fact, I remember reading a large part of it when it first came out and was very impressed by its simplicity.
But a simple tax code doesn’t benefit those who currently make money out of the Income Tax Act being as complicated as it is. These include chartered accountants, tax lawyers, corporates and the income tax officers. Over the years, the Direct Taxes Code has been revised and from what I am told by those in the know of such things, it has become more or less as complicated as the Income Tax Act currently is.
To conclude, the tax system in India currently favours those who need to pay more taxes. This is something that needs to be addressed in the days to come.

The article originally appeared on www.equitymaster.com on Dec 2, 2014