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Column: Formalising the informal sector

There has been considerable consternation over the issue of the large and growing underground or informal economy.

There has been considerable consternation over the issue of the large and growing underground or informal economy. The main focus has been on the drafting of the Lokpal Bill, defining the scope, powers and functions of the Lokpal. Debate has been raging on whether the Lokpal should have jurisdiction over the functioning of the Prime Minister and higher judiciary and whether he/she should have an investigative agency working independently under him/her. Most people are lost in this melee and, in the process, there is hardly any discussion on what the factors that drive the informal economy are, and what policy measures are needed to formalise them. Isn?t prevention better than the cure?

One of the most important sources of the underground economy is in the urban land and housing market. In urban areas, the transactions are many and the values of transactions are large. Further, the impact of fast spreading the informal market is widespread as whoever wants to buy or sell land and houses is automatically embroiled in the parallel economy and forced to break the law. Of course, unlike in the case of ill-gotten money parked in tax havens abroad, this form of underground economy has a vibrant domestic economic activity and creates income and employment.

However, proliferation of the informal sector results in significant resource misallocation. It forces even law abiding individuals to violate the law. As the sector substantially escapes the tax net, a large and disproportionate burden of tax is placed on the formal sector.

There are a variety of laws that have prevented the development of an organised market in this sector. There has been much focus on land ceiling and rent control acts and, even as the Jawaharlal Nehru National Urban Renewal Mission has mandated reforms to free the land market, they continue to constrain formalisation of the markets for urban land and housing in many states. Continuation of these archaic laws, poor information of land records and the prevailing tax treatment of capital gains and stamp duties have been responsible for the proliferation of an informal economy in the sector.

The most important impediment preventing the organised development of land and housing markets in urban areas is the prevailing tax system. The tax system provides enormous incentives to understate the value of properties for both the seller and buyer. In a situation where urban land and housing prices have been sky rocketing, the prevailing system of taxing capital gains provides incentives to suppress the sale value. If the property is held for less than 36 months, the capital gain, which is equivalent to the sale value netted from the value of acquisition, cost incurred in the acquisition and cost of improvements made, is taxed at 20%. In the case of properties held for more than 36 months, the cost of acquisition is indexed for inflation in addition to taking account of the cost of acquisition and improvements. Given that the increase in the prices of urban land and housing has been phenomenal in the last decade, 20% tax on capital gains provides a huge incentive for the seller to undervalue the property transacted. Of course, if the seller acquires another property from the sale proceeds within three years, the tax can be avoided, but that has not helped formalise the transactions.

The proliferation of the informal economy in the realty sector has several repercussions. First, evasion of all taxes in an informal economy is easier. Second, it forces even the law abiding citizens to break the laws. A person who wants to sell his property and pay the relevant capital gains taxes will find it difficult to find a buyer who is willing to declare the true value and pay the stamp duty. Similarly, a law abiding buyer who wants to pay the entire value through cheque will find it difficult to find a seller. Third, it is impossible to estimate the volume of business and the extent of black money generated in real property transactions. Finally, there are serious problems of governance.

The incentive for understating the purchase value for the buyer comes from the high rates of stamp duty and registration fees. Despite attempts to reduce the rates to ?reasonable? levels in the standing committees for stamp duty reform by the Union ministry of finance, many states have rates in excess of 10%. The incentive to suppress the value for both the buyer and the seller creates a dynamics of its own and even the most law abiding person is forced to short shrift the law. Notably, the proposal to merge stamp duty in the proposed GST will add to the incentives to remain informal. Most countries have kept real properties out of the GST base and have a separate stamp duty. However, the rates have been less than 3%, in contrast to India where the tax varies from 6% to 12%.

How do major countries in the world treat capital gains from land and housing for tax purposes? In the US, individuals can exclude up to $250,000 in profit from the sale of a main home (or $500,000 for a married couple) as long as you have owned the home and lived in the home for a minimum of two years during the previous five years. In countries like Australia, Germany, Canada and France, the main or the principal house of the individuals is not subject to capital gains taxation. Surely, land and housing markets in these countries are very well organised.

A good tax system is one that helps formalise the economy and the attempt should be to redesign the tax system to encourage formalisation. Removal of capital gains tax on the principal residence of individuals and reducing the stamp duties to less than 3% can help in formalising the market for land and housing. Given the massive undervaluation of property transactions that goes on, abolishing the tax is not likely to cost substantial money to the exchequer. On the other hand, the gains from this to the economy could be tremendous and a more formal economy is also likely to result in larger tax payments from other sources.

The author is director, NIPFP, and member, Economic Advisory Council to the Prime Minister. Views are personal

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First published on: 05-07-2011 at 02:01 IST
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