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ShareOne of the Fringe Benefits Tax (FBT) provisions in Budget 2005 -- the proposal to tax the employer's entire contributions to an employee's superannuation fund -- exemplifies not just an inappropriately designed proposal: it is public policy at its most perverse. As consultations in the run-up to Budget 2006 are under way, it is an opportune time to revisit the FBT.
To the extent it places a huge financial burden on employers, the FBT will raise the cost of labour compensation and provide incentives for replacing labour with capital. At a time when India is experiencing a demographic "gift" -- with the share of persons in the working age in the total population increasing -- but losing wage competitiveness to China and Vietnam, such a tax-induced shift would be unfortunate.
Moreover, government employees don't come within the FBT net. This perpetuates a dualistic labour market between the private and public sectors -- and reflects a mindset that sees ad hoc revenue measures as more important than their social and economic consequences, such as on international competitiveness, job creation, and capital market development.
The FBT appears to be designed to broaden the tax base by bringing into the net various fringe benefits provided by employers which are usually more difficult to tax in the hands of individuals. This objective has merit, but its realisation requires an appropriate design to minimise rent-seeking opportunities and administrative and compliance costs; and consistency with other reform initiatives such as in pension and healthcare. The FBT's design fails to meet the above requirements.
First, it taxes expenditures that cannot be classified as fringe benefits; provides for special treatment for certain sectors, which opens up possibilities for unproductive rent-seeking opportunities; taxes deemed benefits which can only be arbitrarily valued, thereby raising administrative and compliance costs. In all these areas, it is inconsistent with the move towards a more simplified tax regime.
Second, it is unclear whether the voluntary contributions by employers to the New Pension Scheme (NPS), will be exempt from the FBT. If they are not, two major inconsistencies will result. First, taxing them will violate the EET principle (where contributions and investment returns are tax-exempt, but withdrawals at the payout phase are taxable). A similar violation will occur if superannuation contributions by employers are subjected to FBT, and withdrawals are subjected to taxation under the EET principle.
Third, the FBT taxes the employer's entire contribution to a superannuation fund at the highest marginal rate of 30%.
Currently, India's retirement financing system has a narrow coverage. Only about 10 to 15% of the labour force is covered by the EPFO and by civil service pension schemes. Design inadequacies and lack of professionalism have meant that the EPFO does not provide adequate retirement income to a vast majority of its members.
For some workers in the organised sector, superannuation benefits are an important supplementary source of retirement income. Healthcare financing in India is largely out-of-pocket; government budgetary expenditure and health insurance play an insignificant role.
But as life expectancy rises (the average male life expectancy at age 60 is 16; for women, it is 17); as changing morbidity patterns - with a shift towards 'lifestyle' diseases, which are more expensive to treat - raise healthcare costs, taxing retirement and healthcare benefits under the FBT is inconsistent with the government's professed priorities in the social sector.
Fourth, the FBT as it is structured is inconsistent with international tax practices, and could impact the global competitiveness of firms.
Fifth, the FBT is inconsistent with the objective of achieving greater efficiency in the saving-investment process, an area where India enjoys a major competitive advantage over China. Employer-based superannuation arrangements, provided they are effectively brought under the regulatory purview of the Pension Fund Regulatory and Development Authority (PFRDA), have the potential to assist in the development of financial and capital markets, and lend substance to the development of Mumbai as a financial centre.
How can FBT be restructured? One method worth considering would be to specify the proportion of wages (over and above the mandatory contributions to provident and pension funds) that would be tax-advantaged for superannuation. In the Indian context, a separate ceiling for contributions by employers for health benefits will have high social utility. These could be pegged to 1-2 per cent of total payroll. The ceiling could be specified in terms of proportion of the total payroll of those covered. Consideration should also be given to lowering the current rate of FBT. The revenue erosion will be limited due to the wage ceiling, while gains in retirement security and generation of long-term contractual savings would be considerable.
Budget 2006 provides a good opportunity to revisit and rationalise the FBT.
The author is a professor of public policy, Lee Kuan Yew School of Public Policy, National University of Singapore Email: sppasher@nus.edu.sg
