Finance minister P Chidambaram has the unenviable task of reviving an economy after it was ruined systematically for over 36 months. One of the items high on his to-do list is to reduce the deficit, either by cutting expenditure or by increasing revenue collection. Forget the expenditure cut bit, primarily because it’s political hara-kiri. In a chat with journalists on Monday, he expressed a view that companies paying an effective tax rate of 24-26% — against the applicable rate of 30% plus surcharge — might deserve a second look.

While reporting on the FM’s thoughts, newspaper Business Standard pitched in with a line on “tax foregone” because of deductions granted to the corporate sector (read here). It seems the reporter has added that one line, because no other paper has carried a similar sentence or attributed any such comment to the FM.

Revenue foregone is being equated with revenue squandered, especially in Delhi television studios and punditry columns. The rumblings are familiar: the bill for “revenue foregone” is huge, spend some of that money instead on the poor. The argument is inevitably drawn around the traditional rhetorical lines – tax foregone benefits only the rich (such as industry) while subsidies only benefit the poor. Therefore, the argument goes: abolish all exemptions, tax industry at a higher rate and use the incremental revenue to increase the subsidy budget. This is not only a specious argument but is dubious economics as well. Swaminathan S.A.Aiyar rightly calls it “claptrap” (read here).

It might be instructive to see why the rhetorical argument about revenue foregone can be misleading. For one, the numbers in the revenue foregone statement are based on a clutch of assumptions (for example, projections for 2011-12 are based on revenue foregone during 2010-11) and notional calculations. Therefore, to assume that it is indeed money “diverted” from necessary developmental expenditure is a bit of a stretch. Second, it assumes that all the revenue foregone is actually in the nature of funds granted to favoured entities, which could have rightfully been used for development purposes. That’s also somewhat fallacious. What cannot be denied is the fact that if no exemptions were granted, the government’s revenue collection would have been substantially larger. But, economic policy is all about balancing between different priorities.

The finance ministry tables a separate statement on “Revenue Foregone under the Central Tax System” along with the budget papers every year. This document reveals some of the government’s policy preferences through the lens of taxation. The document states: “Tax preferences may be viewed as subsidy payments to preferred taxpayer. Such implicit payments are referred to as “tax expenditures” and it is often argued that they should appear as expenditure items in the Budget. In this context, the basic issue is not one of tax policy but one of efficiency and transparency – programme planning requires that the policy objectives be addressed explicitly; and programme budgeting calls for the inclusion of such outlays under their respective programme headings. Tax expenditures are spending programmes embedded in the tax statute.”

Taken as such, the argument then boils down to choosing between one subsidy and another. Let’s look at what tax breaks to industry achieve, especially various direct tax exemptions. The debate on revenue foregone usually trains the spotlights on corporates. In the table on “major tax expenditure on corporate tax payers” projected for 2011-12, the largest chunk – Rs 36,468 crore (Rs 33,243 crore actually foregone in 2010-11) — is taken up by the item “accelerated depreciation”.

Now, this is a tax break provided to companies which are investing in acquiring fresh assets. In a sense, accelerated depreciation basically provides a trade-off: it reduces taxable income in the current period in exchange for increased taxable income in the future, with the pointed objective of encouraging asset creation in the present to generate employment and income. This is a legitimate tax incentive used worldwide for motivating businesses to purchase new assets. This not only results in higher productive capacity for the economy but also increases employment opportunities. Had this money gone as a social sector subsidy, it would have been used up for consumption.

The next big chunk is claimed by “deduction of profits of undertakings engaged in generation, transmission and distribution of power (section 80-IA)” – Rs 8316 crore estimated in 2011-12 against Rs 7581 crore in 2010-11. This should be self-explanatory, given the huge power deficit in the country.

What is unmistakeable is the fact that many tax exemptions are targeted towards creating industrial assets, which will generate value, provide employment and become instruments of economic growth. This was followed even at the state level during the long Left Front rule in West Bengal. Most subsidies, on the other hand, induce consumption and do not encourage asset creation.

The data released throws up another big revelation: the effective tax rate (the actual tax paid as a proportion of the total taxable income) during 2010-11 for 2113 public sector companies is lower than the tax rate for the 457,157 private sector companies in the sample: 22.28% versus 24.61%, respectively. Incidentally, the report also states that the effective tax rate for the corporate sector as a whole has been steadily rising – from 20.55% for 2006-07 to 24.1% for 2010-11 – seeming to indicate that a large number of exemptions are being gradually phased out.

Therefore, the conclusion that all tax exemptions are largesse handed out to the wealthy may seem a bit hasty. There is no denying the fact that governments over time – and cutting across party lines — have used the instrument of tax policy to reward their most-favoured industrial groups. But, then that doesn’t turn all tax exemptions into villains. Just like leakages in some of the current entitlement programmes do not diminish the merit of all targeted development plans.

What, however, should be debated is whether the implementation of the policy framework in achieving the stated objectives is actually as rigorous as the original intention. Or, there should be focused debate on whether some exemptions have been created to benefit some favourite industrial groups, instead of demanding that all exemptions be abolished.