The Hindu Business Line : <I>A question of inflation </I>

One of the proposals in the Budget 2007 is to increase the rate of dividend distribution tax on liquid funds and money market mutual funds w.e.f. April 1, 2007, to 25 per cent plus surcharge and cess. Much of the call money comes from organised players, such as banks and liquid funds.

Of late, there has been a big jump in short-term interest rates, especially on call money markets. The fallout of this is seen on other interest rates as well.

It is known that inflation is too much money chasing too few goods, and one of the measures to curtail it is to suck excess liquidity out the system.

The decision to increase the dividend distribution tax on, perhaps, seeks to draw out such excess cash in addition to augmenting revenue. The main investors in these funds are corporates, as they offer companies better scope for tax management, with fungibility.

As a primer, such short-term funds have two broad types of schemes — growth and dividend. The tax treatment of the growth scheme in the short term (below 12 months) is as follows: the difference between the sell and buy price is taxed as short-term capital gains at the normal corporate tax rate. In the dividend scheme the income accretion is distributed as dividend after distribution tax.

Hence, in the dividend scheme the accretion is exempt in the hands of the investor. Earlier, the difference between the corporate tax rate and the dividend distribution tax rate was the arbitrage opportunity. Now, with the increase in dividend distribution tax, there is hardly any scope for arbitrage.

Also, corporates will move out of the call money market and move into other alternatives such as fixed deposits.

As a result, money flow into the call money market may be lower, and this could see short-term interest rates ease a little.

Increasing TDS rates is another measure that will result in extra cash flowing into government coffers, which will help control inflation better than monetary measures.

Curtailing black money and usurious profiteering in real estate have been ignored in this Budget. These are, perhaps, the root causes for the current inflationary run.

(The author is a Chennai-based chartered accountant.)