Unintended Consequences: Shifting DDT to shareholders

The budget for FY21 announced some major changes in the tax structure. The abolition of Dividend Distribution Tax (DDT) was an important announcement in this regard.

DDT is the tax paid by the company on the dividend distributed to its shareholders out of its profits. DDT was taxable at source, and was deducted at the time the company distributed the dividends to its shareholders. It was levied at a rate of 20.56 percent on the dividends distributed by the company.

On a positive note, the budget fulfilled one of the long pending demands of the market i.e. the abolition of DDT. It is expected that the move will benefit small retail investors, mutual funds and foreign portfolio investors. With budget announcement, we are moving to the conventional tax regime with the dividend income being taxed in the hands of the shareholders. The recipients of the dividends from the company will be taxed at their respective income tax rates.

Prior to 1997, dividends were taxed in the hands of the shareholders. In 1997, tax on dividends in the hands of shareholders was abolished, and DDT of 10 percent was levied on the dividend that was distributed. In a way, it acted as an incentive for the investors to make more investments in the equity market. However, in the subsequent years, DDT was raised from 10 percent to the present rate of 20.56 percent (including surcharge and cess) negatively impacting the dividend distributing companies.

By taxing dividends in the hands of the shareholders, we are returning to the regime that was followed before 1997. The intention is mainly to help the foreign portfolio investors. Under the new regime, FPIs could claim deductions in their host countries, and they expect more dividend pay-out from companies. The investors from countries with which India have Double Taxation Avoidance Agreement (DTAA) will benefit from the new regime. However, taxing dividends in the hands of the shareholders can have other unintended consequences.

The concept of ‘unintended consequences’ popularised by Robert K Merton refers to the outcomes of purposeful action that are not intended or foreseen. The same concept could be applied here, to understand the ‘unintended consequences’ of the budget announcement relating to the Dividend Distribution Tax (DDT).  

To quote Milton Friedman, “One of the greatest mistakes is to judge policies and programs by their intentions rather than their results”.

The move to tax dividends in the hands of shareholders will negatively impact those receiving higher dividend income. Especially, the promoters (entrepreneurs) of companies would witness significant increase in their tax burden. For instance, those in the higher income tax brackets will attract a tax rate of around 43 percent. A tax rate of 43 percent is more than double the current DDT rate of 20.56 percent. It needs to be highlighted that the tax rate of 43 percent will apply to promoters in the majority of the listed companies. In the previous budget i.e. for FY20, the surcharge on individuals having taxable income from Rs 2 crores to Rs 5 crores, and Rs 5 crores and above was enhanced. This move made the effective tax rate in the higher income tax brackets to around 43 percent.

An increasing tax burden on the promoters of companies can deter the business climate in the country. Higher tax burden on the promoters (entrepreneurs) of companies gives a message that the government is discouraging risk-taking in the country. Instead of rewarding the risk takers, they are being taxed at a higher rate. In the long run, this would discourage risk-taking, negatively impacting the entrepreneurship in the country. The higher tax rates could also bring down private investments. To move to the next level, India requires more risk takers and entrepreneurs. Finance Minister in her budget speech has also highlighted that entrepreneurship has always been the strength of India. Tax policies in the country should   encourage risk taking and entrepreneurship.

One of the major themes of Economic Survey 2019-20 was ‘wealth creation’. The Economic Survey stresses that wealth creation happens in an economy when the right policy choices are pursued. The survey also provides empirical evidence that shows that wealth created by an entrepreneur has strong spill over effects benefiting various stakeholders in the economy. A strong correlation was exhibited between entrepreneur’s wealth and benefits accrued to employees, suppliers, government, foreign exchange reserves, capital expenditure etc.

However, the current policy to tax the dividends at higher rate in the hands of the shareholders goes against the above argument. The higher tax rates on dividend income act as an obstacle for entrepreneurs to grow their business beyond a stage. In such a scenario, it wouldn’t help the country to transform to an attractive destination for entrepreneurs. Though the budget gave emphasis on start-ups, the policies in the country should also cater to the growth of the start-ups. Unemployment rate in the country is at higher levels, and the number of job seekers is also increasing. In such a scenario, government cannot always be the sole employment provider, and there is a need to boost entrepreneurship in the country. The higher tax rate can force entrepreneurs to shift their base of operation from India to other countries.

In the past years, various developments in the country have deterred the business climate. Along with it, higher tax rates could further worsen the situation. Additionally, philanthropic activities by the business community also take a hit, with the increase in tax burden.

Thus, it is important to consider various unintended consequences of a policy announcement. In the present situation, the government needs to take corrective steps as it could have long-term negative implications on the economy.