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Chapter III
Base for taxation
3.1 Taxes are compulsory payments which citizens in a country are required by law to make to the Government for defraying the cost of providing public goods and financing transfer payments. Therefore, they have to be financed from taxes. This immediately raises the question of the basis of allocating the costs i.e. the basis of determining the distribution of tax payments.
3.2 Since taxes are payments without a direct quid pro quo (except good governance) and are meant to cover the cost of common goods and services, it is generally accepted that individuals’ or households' tax liabilities should be according to their ability to pay. Such a basis is considered fair. If this be granted, it would follow that those with equal abilities should make equal tax payments and those with higher abilities should be asked to make proportionately larger payments. This rule sounds simple enough but, in translating the principle into practice, a number of problems arise and several other considerations may also have to be kept in mind.
3.3 Two alternatives, income and consumption, are generally accepted as the best indicators of ability to pay. Traditionally, income has been taken as a test of ability to pay (or index of potential welfare), and direct taxation has been mainly based on income. Consumption can also represent the ability to pay and has been used as an indicator.
3.4 If equitable taxation should be in accordance with the capacity to pay of the taxpaying unit, and if income is to be taken as a measure of the capacity to pay, it must be so defined for tax purposes as to reflect adequately the potential economic welfare of the individual concerned, i.e., the capacity he has to spend during a year without affecting his net worth as at the beginning of the year. This means that the definition must be comprehensive enough to include all accruals to spending power. The conventional definition of income does not do so. Ideally, we need a comprehensive definition of "income" for tax purposes. Such a definition of income would include, apart from gifts received,
(a) all earnings including labour, investment and business income net of cost of earning and depreciation ;
(b) net accrued capital gains i.e. net increases in the value of capital assets owned ;
(c) value of services or utility of non-business assets owned net of cost of maintenance and depreciation ;
(d) imputed value of the services rendered by the members of the family ;
(e) windfall gains ; and
(f) casual receipts, e.g., lottery prizes.
3.5 The conceptual basis of the definition is clear : the definition equates income to consumption plus change in net worth. However, in practice it is not possible to measure satisfactorily all the elements included. First, imputation of proper values to items of income in kind flowing from non-business assets and services rendered by the members of the family unto themselves is almost impossible to measure and, therefore, they have to be left out of the definition. This is not, however, considered a serious problem except for house property. Second, in regard to changes in the present value of all assets owned by an individual, problems arise when they are not normally marketed. Two examples may be mentioned : (i) the change in the current value of pension rights ; and (ii) the change in the value of the assets of closely owned businesses. Third, even when market values are known, taxing an increase in capital value on accrual, instead of on realization basis, will create hardship. Fourth, under a comprehensive income-tax, strictly speaking, the pro rata share of each shareholder in the undistributed profits of companies should be allocated to him and included in his taxable income. This cannot be done for reasons which are well recognised. Fifth, even in the absence of inflation, it is difficult to accurately measure economic depreciation. Since depreciation allowance has to be granted on the basis of rough estimation, the measurement of business income is at best an estimate and the true magnitude cannot be known.
3.6 If the pro rata share of undistributed profits of companies cannot be taxed directly in the hands of the shareholders, the introduction of a personal income-tax will lead to the formation of incorporated entities and avoidance of the tax by not distributing the profit. The intention would be to take profits out in course of time in the form of capital gains. To prevent such means of avoidance, a tax has to be imposed on the profits of corporations. This leads to the phenomenon of the so-called double taxation of dividends, which apart from the extra burden placed on equity holders, creates a bias towards debt finance.
3.7 The real income flowing from non-business assets such as consumer durables may have to be ignored for administrative reasons. But it would not be proper to leave out the real income or utility flowing from owner-occupied houses, because rental income from house property has to be included in taxable income. There would be taxpayers who would be renting their houses and living in rented houses in other places for reasons of business or for some other reason. As against this, those taxpayers who live in their own houses do not have to pay rent. The two groups would be treated equally only if the imputed income from owner-occupied houses is included in taxable income. But imputation of income is not easy when a house has not been rented for a long time or at all. Also, if in course of time rents rise substantially, the imputed income might become a large part, or exceed, the other income of the owner-occupier. Hence, a neat solution is not possible, and often the income from owner-occupied houses is not subjected to tax. Thus the comprehensiveness of the definition of income is further eroded.
3.8 In line with the principles and the problems discussed above, the Code seeks to adopt, to the extent possible, a comprehensive definition of income. Therefore, income for the purposes of this Code will, in general, include all accruals and receipts of revenue and capital nature unless otherwise specified. Exemptions, if any, have been made on the consideration of positive externalities, encouraging human development and reducing risk, equity, and reducing compliance and administrative burden. Further, on account of the assignment of the taxing powers under the Constitution to the States, agricultural income has been excluded from the scope of this Code. Some exceptions, which are essentially in the nature of deferrals, have also been provided in the Code with a view to mitigating the problem of liquidity.
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