Vijay Kelkar should know that Nyaya, the science of reasoning, expounded by Gautama, is unforgiving. If you do not follow its strict rules, it makes you create nonsense out of sense.
That at least is what has happened to the Kelkar Task Force's recommendations on corporate tax.
With impeccable accuracy Kelkar and his colleagues justly established the premise that 'it is important to recognise that it is individuals or citizens who pay taxes, and not corporate buildings or plant and equipment.'
The task force then argued that 'since corporations are not persons, strictly speaking there is no case in equity for taxing the profits of companies as such. The tax should be levied only on the owners, that is, the equity holders, by attributing the profits of the companies to the shareholders.'
Having set forth the premises, one might suppose that the only consistent conclusion of this syllogism must be that there should be no tax on corporate profits.
Yet the task force chose to 'levy a tax at the corporate level at the rate of 30 per cent being the maximum rate of personal income tax and exempt all dividends and long-term capital gains from tax in the hands of the shareholders.'
Unfortunately, the task force came to an invalid conclusion because they claimed that in an integrated tax system it made no difference on how the levy was imposed. Yet this mistake confused the logic of their argument.
There is no difficulty in collecting taxes from the company as an agent for equity holders on distributed profits but the task force was confused by the proper treatment on undistributed profits.
Yet the fact that undistributed profits are retained within the company is not a reason for abandoning logic. Whether profits are distributed or retained, they belong and have been earned on behalf of the class of shareholders; this income is therefore taxable.
Retained profits can be deemed as income reinvested by shareholders after distribution and therefore taxable in the same way that distributed profits are taxed. Since tax in both cases would be collected from the company there could be no practical difficulty in that.
The only distinction that would be required is that income thus taxed should not suffer a second dose of tax when it comes eventually to be distributed in subsequent years. Thus, companies would need to maintain a record of taxed reserves.
In either case, the income would be taxed, whether it is actually distributed or retained by the company.
If such a procedure were to be adopted there could be no inequity in personal taxation. But it would have the merit of effectively avoiding tax on corporations as Kelkar's syllogism would validly imply.
The burden of tax should in progressive systems vary according to the individual's personal income, but as the Kelkar task force has chosen to recommend the highest level of tax from all income distributed, the same rate must apply to the undistributed portion.
If all levels of income are taxed at the highest marginal rate, the concept of progressive tax becomes irrelevant.
The consequence of Kelkar's syllogistic error has prevented the task force from recommending what might have become the most dynamic corporate tax system in the world.
Had Kelkar persisted with removing the tax on corporations, he would have immediately eliminated all special incentives given to specific industries.
If profits are not taxed at all, it follows that all exemptions and incentives to corporate income are automatically irrelevant.
If both distributed and undistributed profits are taxed as the income of equity holders, all exemptions would only be relevant to the personal status of the equity holder and not the status of the corporation.
Further, abandoning corporate tax would align company profits with company cash flows in a structurally useful and transparent manner.
In such a system the sole difference between corporate cash income and corporate profits would be depreciation and loan repayments.
A company would not borrow to distribute money as profits for all distributed profits would automatically be taxed as attributable to individual equity holders.
Further, it would make sense to distribute profits from accumulated depreciation for precisely the same reasons. The consequence is that accumulated depreciation can only be used for investment or repayment of loans.
It therefore follows that accelerated depreciation would lead to faster loan payments or earlier investment.
Either result would be desirable. The argument that persists for the right rate of depreciation would become superfluous.
So long as the rate of depreciation does not exceed 100 per cent, it should not matter to the government if some companies prefer to depreciate faster than others, for, in a business cycle such fluctuations in government revenue would be compensated by faster rates of investment.
Depreciation funds could not be transferred to personal income without payment of tax.
But the most important aspect of reducing corporate tax to zero is that the incentive for special concessions would disappear.
After all, if an organisation is not taxed at all it cannot plead for special incentives for its form of income.
At present it is possible, for let us say, software income earners to be exempted from certain direct taxes because of the nature of their source of income which arises from exports or from certain forms of development; but if there is no tax on corporate income there is nothing that they can be exempted from.
They would then have to plead for a subsidy which is precisely the complication that the Kelkar task force wished to impose on those looking for special concessions.
The failure to achieve their purpose was because they could not accept the logical consequence that their analysis presented.
If the task force had pursued their analysis to its logical conclusion, the result would have been the abandonment of all corporate tax and the attribution of all income earned by companies to their equity shareholders.
Such income would be taxable at personal rates regardless of whether it was distributed or not. The practical complications envisaged by Kelkar for such an attribution are not as great or as remarkable as they imagined.
For the basic concept that emerges is that incomes should be taxed as they would be if companies distribute their entire profit to their equity holders. There is nothing so startlingly revolutionary in such a concept.
There was a time when private trading companies were required to distribute 90 per cent of their profits to their shareholders. This was deemed iniquitous because the marginal rates of personal tax were absurdly high.
Now that it has broadly been accepted that high marginal tax rates are detrimental in any system, it is possible to revive the notion that corporate income ultimately belongs to its equity holders and should be taxed accordingly.
That is what the Kelkar task force argued for, and that is what makes the report so admirable, but, as often happens in economics, they finally lost their nerve in pursuing their recommendations to their logical conclusion.
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