Dividend income -- To tax or not to tax

M. S. Narasimhan

The debate on tax on dividend income has resurfaced. It is an issue that has changed the perceptions of stock market investors on Budgets several times earlier. Pre-1997, the market had high expectations on this issue and reacted negatively when successive Finance Ministers disappointed investors.

Background: In 1997, Mr P. Chidambaram exempted the dividend from taxation but asked the companies to pay a 10 per cent tax on the dividend distributed -- a unique effort in the world of tax on capital market investments. Except for a few tax consultants and financial economists not in favour of the simplification of tax law, the proposals have been welcomed.

There was not a murmur from any industrialist or industry association. The proposal relieved investors about dealing with income-tax authorities on dividend income.

Though the firms were asked to pay 10 per cent tax on dividend outflow, the corporate sector viewed this as a reduction on total capital cost because the tax cash flow of the investors improved due to this new proposal. Though the Government pegged the dividend tax rate at 10 per cent -- the lowest tax rate applicable to individuals -- every rupee declared as dividend was brought in to the tax net and the complex exemption structure was made redundant. The scheme benefits the Government by taxing every rupee given as dividend at source.

Swells government kitty: If one considers unlisted companies, companies for which data is not available and subsidiaries, the actual dividend tax collection should have been much higher than commonly figured. It is unlikely that the Government would have collected this much tax on dividend with the existing dividend tax provision with numerous exemptions.

It also enabled the Government to prevent any large-scale outflow of cash, in the form of dividend, and thus affect capital formation. At the same time, it also increased the Government's revenues. The provision seems to satisfy everyone and it was no wonder that Mr Chidambaram's 1997 edition earned the moniker `Dream Budget',

Taxed at higher rate: The dividend distribution tax is now being criticised. What went wrong? The trouble began last year when the dividend distribution rate was hiked from 10 per cent to 20 per cent. The Sensex immediately fell 293 points on the Budget's presentation.

A large number of companies subsequently rushed to advance the dividend payment to prevent larger tax outflow. Though there is no clear evidence on the lowering of the dividend, it would be natural for firms to slow the growth of dividend to conserve tax, since capital gains are taxed at lower rate of 10 per cent.

Seeking rollback: The industry is now attempting to roll back the increase by making a representation to the Finance Minister. The Parathasarathi Shome Tax Advisory Group has suggested the abolition of the dividend distribution tax. While industry is demanding a reduction, the Finance Ministry is now worried about losing Rs 3,000 crore if the dividend distribution tax is abolished.

Interestingly, in his proposal to increase the rate from 10 per cent to 20 per cent, the Finance Minister, Mr Yashwant Sinha, has neither cited a different reason for the hike nor quantified the revenue implications of the proposal. Nor did the then Finance Minister when the proposal was originally introduced in 1997. Thus, we can assume from the public statements of the two Finance Ministers that the Government is not concerned with the revenue impact of this proposal. Else, the revenue could have been maximised by increasing the tax rate to 30 per cent on the assumption that investors would be rich anyway, and that they should pay a tax equal to the highest tax bracket.

Flawed arguments: The Government hiked the rate in the last Budget to narrow the gap between tax on interest and dividend. The argument is simple: When the interest income is taxed at a rate depending on investors marginal tax rate, varying from 10 per cent to 30 per cent, the dividend receiver should be taxed accordingly.

The rate of 10 per cent on dividend income may discourage investors from investing in any debt-related investments such as fixed deposits of banks. This logic has several flaws. First, investment in equity and debt have different levels of risk and a marginal variation of the tax rate is not adequate for people to move from risk-free bank deposits to risky stock market investments.

If the Government wants to test this hypothesis of a shift from deposit to equity investment, it should do so either on actual figures or through survey results. Further, tax on dividend is paid out of the income of the corporate entity, which is already taxed at the highest rate of tax (35 per cent).

On the other hand, the companies are not paying any tax on the interest paid. The part of the income used for interest payment is exempt from tax. Interest suffers tax only once, whereas dividend suffers tax twice -- earlier from two tax entities and now from the corporate sector on two separate items. In fact, the Government collects tax indirectly on undistributed profit since it is reflected in the form of capital gains. Thus, the tax rates on interest income and dividend income are not comparable and hence the new reason given for dividend distribution tax is not sustainable.

Pre-1997 rule: There is also a demand from certain quarters to roll back tax on dividend income to the pre-1997 rule. It means to tax dividend receivers at marginal rate and bring back all exemptions. When all concerned with tax on dividend -- the investor, the corporate sector and the Government -- are happy with the new system of taxing the dividend payer, there is no need to reverse the principle. A flat tax is generally favoured by the payers, particularly if the rate is low.

Many Asian countries have introduced a flat Goods and Services Tax (GST) of 3-5 per cent. Similarly, there is no major debate on any of the indirect tax proposals in this country and the Government has raised the indirect tax rate on many items either directly or by rationalising the rate to a few slabs.

Thus, the flat tax rate concept, successfully tried on dividend income, has to be expanded to `other income' on individuals instead of scrapping the concept. Since it is one of the few innovative tax concepts, it is worth the Government's while to set up an exclusive committee with due representation from industries and investors to examine the concept.

(The author is an Associate Professor, Indian Institute of Management, Bangalore, and can be reached at msn@iimb.ernet.in.)