The recent news about the allegation of duty evasion of Rs. 570 crore against Cadbury India by creating a ghost unit in Himachal Pradesh does not come as a surprise.
It is well known that ‘area-based’ tax incentives result in huge evasion and avoidance of tax, while not actually helping these industrially-backward areas to develop.
Tax Incentive Promotes Tax Avoidance?
Last year (2014-15) India lost an estimated Rs 8,900 crore in corporation tax revenue due to the various ‘area-based’ incentives offered. This is just the tax-avoidance.
The actual revenue lost —if you factor in tax evasion — is sure to be much higher.
The problem with many developing countries is that they want to pursue too many objectives through tax policy and in the process end up enormously complicating it. In India, besides raising revenue, tax policy is designed to achieve objectives like regional development, boost infrastructure, encourage people to save, build houses...so on and so forth.
Naturally, this complicates the tax system and allows the tax collector wide discretionary powers, resulting in rent-seeking and higher compliance cost. It also gives rise to tax evasion and lobbying by various special-interest groups looking for tax concessions.
Time to Do Away with Area-Based Tax Incentive
The most undesirable consequence of ‘area-based’ tax incentive is the distortion it creates. While the logic is to encourage companies to set up shop by lowering their cost of production, what happens on the ground is that these incentives in fact result in a flight of capital from the regions that are sought to be developed.
Real manufacturing industries -- employing significant number of local labourers or sourcing local raw materials -- are not the ones that actually come up in places like Himachal Pradesh. Instead low volume–high value industries with very little value addition, exploit the loophole.
These industries have much lower transportation costs in procuring their inputs or transporting the final goods. In Himachal, most industries are concentrated around Baddi, Nahan and Una districts which are the neighbouring districts of Punjab and Haryana. They came up by de-industrializing Punjab and Haryana after the incentive regime was put in place.
This opens up an easy avenue for tax evasion. Often, the production in other places is shown to have been produced in these districts, to evade tax through misclassification. It is also possible to produce them in the adjacent districts and transport them simply for final packaging and claim tax concession.
Instead of giving ‘area-based’ tax concessions these regions could be better industrialised by creating a competitive environment so that they can produce goods and services in which they have a comparative advantage.
(Dr. M. Govinda Rao is Former Member, Fourteenth Finance Commission and Emeritus Professor, National Institute of Public Finance and Policy, New Delhi.)