Introduction
Tax incentives for infrastructure have a Janus-like presence in contemporary public finance. On one side, they are offered as a neutral tool to correct market failures: to reduce the cost of capital, to mobilize long-term investment in capital-intensive undertakings, and to speed the supply of socially desirable assets. On the other side, when designed and administered as tax exemptions, deductions, or specially designed pass-through regimes, they have the economic and political effect of subsidies outside the conventional budgetary process. This article suggests that the tax incentives for infrastructure in India should be understood and evaluated in accordance with the theory of tax expenditure and should be subject to the same procedural rigor, transparency, and constitutional review that applies to conventional expenditures. This article introduces the concept of tax expenditures, examines the institutional structure of tax incentives for infrastructure in India, and then evaluates their distributive and constitutional implications in light of Article 14 before offering recommendations.
Tax Expenditure: Conceptual Foundations
Tax expenditure is the term given to the special treatment given to taxpayers which has the same effect on the budget as a direct expenditure. Exemptions, tax holidays, accelerated depreciation, and special rates and deductions all cause the government to lose revenue and therefore represent a form of subsidy. The analytical power of the concept of tax expenditure is given by the following three characteristics: First, the concept acknowledges revenue loss as a tool for policy; second, the concept emphasizes the effects on the distribution and efficiency of the allocation of revenue; and third, the concept requires a procedural action: the need for the expenditure to be justified so that the budgetary trade-offs are made transparent to parliament, society, and the auditing authorities.
India has institutionalized this understanding unevenly. For example, the budget documents of the Union Government include ‘Revenue Foregone’ statements for Union taxes since the mid-2000s. Scholars and fiscal institutions use these disclosures to estimate and evaluate the extent and structure of India’s tax expenditure. However, the disclosures are partial, the methodology is not always transparent, and the political phenomenon of granting sectoral carve-outs, often couched in the rhetoric of ‘development,’ continues unabated. The academic literature emphasizes the need for tax expenditure to be systematically cataloged, evaluated on conventional parameters of performance, and compared with other forms of direct subsidies lest they continue as ‘hidden’ policy tools with pernicious effects on issues of equity and accountability.
The Architecture of Infrastructure Incentives in India
India has a range of tools available under its statute book and fiscal policy, which are targeted towards the infrastructure sector, including tax holiday-type deductions under the Income Tax Act for certain infrastructure activities, sector-specific exemptions from central indirect taxes under specified conditions, concessions by the states such as stamp duty waivers and discounts on electricity duty, and the granting of tax benefits for investment vehicles such as Infrastructure Investment Trusts (InvITs) and Real Estate Investment Trusts (REITs) for mobilizing investments into the infrastructure sector. Additionally, the Union Budget and State Budgets periodically offer one-off concessions for catalyzing private sector investments in the roads sector, ports, power generation, telecommunications, and data centers, among other infrastructure areas. From a tax expenditure perspective, these are not mere policy options but actual transfers of resources, which have a direct impact on the government’s revenues and the pattern of benefits being delivered to different sectors of the economy.
Two developments are quite significant: the first is the formalization of the concept of revenue foregone, which has provided a factual basis for the empirical examination of the fiscal impact of tax expenditure; the second is the legislative recognition of the concept of ‘pass through’ tax status for certain categories of investor vehicles, such as those covered under the provisions applicable to business trusts. Both developments warrant close examination because they impact the extent to which support is provided transparently for the public good or otherwise flows into the hands of investors rather than project companies.
Why Infrastructure Incentives Are ‘Hidden Subsidies’
From an economic perspective, the tax holiday or the accelerated depreciation allowance can be seen as reducing the effective price of capital for the firm. If the concession consists of the exemption of the receipts of interest at the trust level, subject to taxation at the level of the unitholders, who are the ultimate beneficiaries, this is a pass-through. From the political economy perspective, the use of the tax instruments can be justified on the following grounds: the use of taxes avoids the visibility of the appropriation process, taxes are administratively easier to implement, and taxes can be designed to favor privileged beneficiaries. However, the problem with the use of taxes for the government, from the normative perspective, is that the process of designing the tax policies escapes the scrutiny of the appropriation process. When the government chooses to use taxes, the government, in effect, chooses an off-budget policy.
The reporting in India on the fiscal side has improved to the extent that one can observe that these tax expenditures are significant in scale and are concentrated in particular areas through periodic reporting. However, the methodological limitations in reporting, for example, the baseline used to calculate “revenue foregone,” suggest that the overall figures mask the complexity. The political implication is that the incentives to infrastructure can be justified on the grounds that they are pro-growth without any discussion on their distributional and efficiency aspects. This is the hallmark of a “hidden subsidy.”
Constitutional Dimensions: Article 14 and the Rule Against Arbitrariness
The judicial examination of tax preferences in India has been not only textual but also constitutional and has centered on Article 14. The test of constitutionality of a classification for fiscal purposes is well settled. It is to be determined whether the intelligible differentia has been kept in mind and whether the classification has a rational nexus to the object to be achieved. The decisions of the Supreme Court in a series of cases make it amply clear that tax legislation is not beyond the purview of Article 14.
A relevant example of such a ruling can be found in S.K. Dutta v. Lawrence Singh Ingty, wherein the Court struck down a particular section on the grounds of an exclusionary carve-out without intelligible connection to the legislative policy. The relevant legal principle that can be deduced from such rulings is that differential tax treatment has to be justifiable on the basis of objective criteria to ensure that the differential treatment is not arbitrary and serves the particular policy objective. With respect to differential treatment in the case of infrastructure concessions, Article 14 requires that the state’s decision to provide differential treatment to particular projects, entities, or investors has to be rationally related to explicit and demonstrable objectives such as market failure correction, public goods creation, and correction of deficits in particular regions. Failure to do so can lead to a very real threat of constitutional invalidation.
Distributional and Efficiency Consequences
The normative argument that infrastructure incentives are good assumes two empirical propositions: that they alter the investment decision in favor of socially desirable projects, and that they do so at a lower cost or with fewer distortions than grants or regulatory reform. The empirical support for both propositions is limited. For some projects, such as high-risk early-stage greenfield transport corridors in less developed regions, incentives may be necessary to overcome coordination failures. For many projects, however, the incentives pay rents to well-established firms or to capital-rich investors who would have invested anyway in the absence of a concession.
The pass-through treatment of business trusts is a good example of this. In this way, the tax laws can be designed to make infrastructure appear more tax-efficient through the creation of InvITs and REITs that avoid tax but tax investors on receipt. However, the incidence of the benefit, whether it is received by retail investors, institutional investors, or the sponsor through asset value, is a matter of variation. Unless a careful assessment of incidence is made, a large number of these benefits will end up going to well-connected individuals rather than the intended beneficiaries such as underserved regions and consumers. In other words, the arbitrary combination of selective concessions and reporting cannot easily be squared with the principles of horizontal equity.
Transparency and Accountability: The Limits of Current Practice
The procedural solution to this problem of hidden subsidies is to ensure transparency in the reporting of tax expenditure. India’s practice of issuing revenue foregone statements is a good starting point in this regard. By making the quantification of carve-outs a matter for public debate in the domain of revenue policy, India has done well in this regard. However, this is not sufficient to ensure accountability. For that, we need to add three institutional dimensions to this procedural solution. First, we need to have a methodological approach to measuring tax expenditures. This includes a baseline and a set of underlying behavioural assumptions. Second, we should have an ex-post evaluation of major tax incentives in light of underlying policy objectives using cost-effectiveness criteria. Third, we should have parliamentary oversight that includes major tax expenditures in the budget dialogue, allowing different ministries or auditors to question and suggest policy changes.
So far, these complementarities are limited. For one, the existing statements of revenue foregone are often limited in scope and exclude concessions and indirect effects at the state level. In a second respect, parliamentary scrutiny of tax expenditures is not always subject to the same level of intensity as that of direct appropriations. This is where the problem of policy drift comes in, where ad hoc concessions gradually build into a complex system of exemptions that is hard to reverse. The solution is to be found in a more robust norm of transparency and evaluation of tax expenditures with the same level of rigour and institutionalisation as direct spending.
Evaluating Specific Instruments: Tax Holidays, Accelerated Depreciation, and Pass-Through Vehicles
A doctrinal and empirical assessment of these commonly used instruments will serve to illustrate the above thesis. Tax holidays and sectoral income tax deductions, which were traditionally granted through sections of the Income Tax Act that granted a premium to infrastructure or power projects, are crude instruments. These are subject to timing arbitrage, capture by large firms, and a general lack of transparency. For projects where the binding constraint is not tax but rather regulatory, tax holidays are a suboptimal solution to the problem. Accelerated depreciation and investment allowances are more effective if they are used to reduce the user cost of capital for high-capex projects. However, without a sunset clause, these allowances become permanent.
The pass-through treatment of business trusts, which is codified through provisions that determine that distributed income has the same character in the hands of unit-holders, provides tax neutrality between direct and indirect investment in infrastructure. The rationale for providing pass-through treatment is to remove the problem of double taxation and to promote intermediation. At the same time, there is a risk that such a regime will be used to appropriate tax savings to sophisticated investors and reduce the tax base in ways that are not immediately apparent at the appropriation level. For the state to explicitly provide pass-through treatment to InvITs and REITs, there is a need to establish why this is a structural change that is required and how this change is to be related to the achievement of state objectives.
Constitutional Limits Revisited: Reasonable Classification and Fiscal Equality
When the legislative decision on tax incentives is challenged on the grounds of breach of Article 14, the reasonable classification test is applied. There should be intelligible differentia and a rational nexus to the legislative objective. However, the courts have also adopted a certain latitude in this regard in the determination of fiscal policy. This means that only obviously arbitrary or discriminatory tax incentive decisions are set aside. However, the overall system also sets two constraints on the state: first, that classifications should not be unrelated to the stated object; and second, that special treatment to a limited class without sufficient justification may also be set aside. The implication for tax incentives to infrastructure is that legislative drafters should ensure that legislative purpose is recorded, that objective tests are applied to determine eligibility, and that proportionality features are built in to ensure that the incentive has a rational relationship to a legitimate objective.
The jurisprudential consequence of all this is that constitutional law should be thought of as a check on the worst excesses of tax expenditure practice, rather than a replacement for sound fiscal governance. Where the political economy creates pressures for “stealth transfers” through tax instruments, judicial review provides a corrective, and where the political economy creates pressures for “sophisticated, transparent, and evidence-based incentives” with “sunset” and evaluation provisions, constitutional risk is lower.
Policy Recommendations
Firstly, India should improve and standardise its tax expenditure reporting methodology. A baseline should be established to ensure that behavioural assumptions are transparent. State-level concessions should also be incorporated in a single statement on ‘Fiscal Support to Infrastructure.’
Secondly, major tax incentives for infrastructure should be evaluated on a mandatory ex-post basis. If the incentive involves a material amount of revenue foregone, then evaluation after a set period should be conducted to assess its additionality, cost per unit of output, and incidence. If the incentive fails to prove its value compared to alternatives, then it should be repealed.
Thirdly, the legislature should introduce procedural rules that require that any new major tax expenditure should be accompanied by a ‘sunset clause,’ ‘performance conditions’ based on project delivery or regional development outcomes, and ‘disclosure’ of beneficiaries and cost projections.
Fourth, where pass-through regimes are implemented (such as in the case of InvITs), it is suggested that they should be accompanied by a requirement of reporting that reveals the structure of unitholders, sponsors, and the economic incidence of distribution to ensure that public support is not used for private rent-seeking purposes.
Fifth, it is suggested that state governments and the Centre should collaborate, as a significant number of tax incentives in the infrastructure sector result from a combination of state and Central government policies. This will help in creating a framework for approvals and reports, which will help in avoiding a race to the bottom among states.
These suggestions, it is believed, will help in transforming tax incentives into a more transparent tool that can be compared to public expenditure, thereby making it more in consonance with the principles of transparency in public finance and equality enshrined in the Constitution.
Conclusion
Infrastructure incentives, as a tool of economic policy, are legitimate. But so is legitimacy linked to transparency, evidence, and procedural accountability. The absence of checks and balances, which is a hallmark of a democratic system of governance, is violated if tax incentives are taken out of the budget and presented in a different guise. The Constitution would not approve of any such inequality if it were to be made explicit. The attempt to frame infrastructure concessions in the guise of tax expenditure, and dealing with it in that fashion, opens up the possibility of a more honest debate about public policy choices. The challenge is as much about the systems as it is about the substance: it calls upon finance ministries, legislatures, and courts to see tax law as a core tool of public policy, and to manage it with the same intensity that is reserved for other public expenditure policies.
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