Income tax in India – Evolution over the years and way forward

Note: This is not a budget analysis, or a budget summary. This is purely an opinion piece.

How is income tax expected to evolve in India? Will the new tax regime become mandatory? Will the government do something for the middle class? Or will they continue to focus only on the lower & higher income groups (which bring in the votes and notes, respectively). How does a government get more people to pay their taxes? I will attempt to discuss some of these issues in the next few paragraphs.

First off, current affairs - Was Union Budget 2023 really for the middle class?

Note: Middle class is defined as income in the range of Rs. 5-30 lakhs.

The FM has reduced tax rates in the new regime for income up to Rs. 15 lakhs to make it more attractive – at a cost of 35,000 Cr to the exchequer - a measly 5% of the total personal income tax collection. This is a brilliant move since it covers ~70% of the middle-class population (who have an income in the range of Rs. 5-15 lakhs) and gives them 10-20% tax savings at a nominal cost to the treasury. The impact is low as 80% of personal income tax is paid by those whose tax liability is more than 1.5 lakhs p.a., i.e., their income is more than 15 lakhs (Source: LiveMint). The budget has not given any meaningful reduction for this group of middle-class taxpayers (income range of 15-30 lakhs, forming 30% of the middle-class population). While this is good for progressive socialism, it leaves a lot of unwilling taxpayers (especially in the middle class), who always look for ways to avoid paying taxes (more on this below). Further, the surcharge reduction in the highest bracket (reduction of the maximum marginal tax rate) is a step in the right direction to rationalize the overall tax regime, but it is inconsequential for the middle class.?

With this out of the way, let's come back to how our tax regime has evolved over time, and what should be the way forward.

In this section, I will discuss how I believe the tax regime is likely to move forward. I will attempt to contextualize it based on current peculiarities of the system - limited tax base as a percentage of total population, a complex tax regime and high tax rates, to name a few. I will briefly touch upon the reasons and challenges posed by these peculiarities, and the potential steps that could help us solve them and move in the right direction over the medium to longer?term.

The old tax regime will be phased out, probably in the next 2-3 years. This is a great step towards simplification of the tax code in India (it is among the most complex tax regimes in the world).?What needs to be seen is whether the government will force this shift, or if they can make the new regime more attractive and get taxpayers to opt for it voluntarily. In the current shape and form, most taxpayers are unlikely to find it more attractive than the old regime, because they will ideally still invest in most of the prudent investments which were incentivized in the old regime through tax breaks.

One must note the taxpayer pool in India is concentrated (low coverage), with high tax rates. The low coverage makes it necessary to have higher rates.

1. Coverage: Only ~6% of the population files tax returns, and only ~1.5% of the population actually pays taxes. In other comparable countries, this percentage of population paying taxes is in the ~9-10% range (Source: The Economic Survey of 2015-16) (the corresponding number is 40-50% in developed nations).

The coverage is low because a large section of population does not fall in the taxable income bracket - now Rs. 7 lakhs in New Regime - this ~4x the per capita GDP, vs ~1-1.1x in comparable countries (Source: Finshots).

Reducing this minimum tax income slab to closer to per capita GDP (Rs. 2 lakhs) will largely expand the tax base - at a very high-level estimate, this will more than triple the number of people paying tax (bringing us closer to the average of comparable countries). Based on high level estimates from public data, this will also increase the tax collection by ~20% (this cushion can also be used to offer some rebate to those with income below 5 lakhs, while still ensuring they are brought under the tax net). However, it is unlikely that any government will take this route because of political ramifications.

Further, agriculture employs 55-60% of the population, but agricultural income in India is exempt. While majority of Indian farmers earn paltry sums of money, there are lots of rich farmers who are outside the tax net (land ownership more than 10 hectares). NITI Aayog proposed bringing large farmers in the ambit of tax a few years back, but this discussion was quickly brushed aside fearing political backlash.

2. Tax Rates: Personal tax rates in India are very high - a function of both income slabs & tax rates. (Note: Rates are high in US & EU as well, but they also come with a host of social benefits, and hence are not a fair comparison)

2a. Income slabs: Higher income tax slabs in India are not annually adjusted for inflation, as is done in many evolved tax regimes (like US). The 30% income bracket has been at Rs. 10 lakhs (Rs. 15 lakhs now only for new regime) for the last 10 years (last revised in FY 2012-13). At a 6-7% inflation rate, this number should have been revised upwards to Rs. 18-20 lakhs by now. In effect, large part of the middle class is paying tax in the highest slab rate (middle class income is Rs. 5-30 lakhs, while income attracting highest tax rate is Rs. 10 lakhs in old regime, 15 lakhs in new regime).

2b. Rates: The last time that the tax rates were reduced was in FY 1997-98 (from 15%, 30%, 40% to 10%, 20%, 30%). This was part of govt effort to rationalize tax rates from the highest point of 97.75% to 30% over a 20-year period. This was an important change over time to make the tax regime reasonable. However, over the last 25 years, no changes have been made to these rates, while the highest rates have moved back up to 42% (now 39% in new regime). The definition of taxable income has continuously expanded as well.

There is merit in rationalizing the highest tax rate in the new regime (from 30% to 25%). This drop will accelerate the movement of people to the new regime (and help simplify the tax code) as the net tax liability becomes more lower / at par with the old regime, without having to go through the complexities of claiming exemptions and deductions. In encouraging this voluntary shift to the new regime, the govt is also not likely to face a major revenue loss in the long term either. In fact, it is quite possible that it will be a net positive for the exchequer.

1. Relief reduction: The new regime does away with exemptions and deductions. As a result, it reduces the avenues for obtaining tax relief and will increase tax collection over time. Let’s look at it mathematically. As mentioned earlier, 80% of tax is contributed by those earning more than Rs. 15 lakhs. Further, only 1% of Indian taxpayers earn more than Rs. 50 lakh (Source: Times of India). Keeping this 1% aside, the income range of 15 lakh to 50 lakh will cover taxpayers contributing bulk of taxes. A 5% tax rate reduction (25% tax instead of 30% in the highest bracket) for this income bracket would amount to a revenue loss of ~Rs.1.5 lakhs per person (taking 30 lakhs as the median income in this bracket). Average deductions / exemptions claimed by taxpayers in this income bracket would be ~5 lakhs in the old regime (80C, HRA, NPS, Health Insurance, Interest on Home Loan, etc.). 30% of this amount also comes out to ~Rs. 1.5 lakhs, which the govt is providing as tax relief anyway. Thus, net revenue loss to govt may be negligible.
2. Cost savings: Higher adoption of new regime will drive huge savings in administration, compliance, and legal costs in the system, which are incurred to manage a complex tax regime, with unending litigation, appeals, documentation, corruption, et al. When these savings are considered, this move could be a no-brainer for the govt.

Making the new regime genuinely attractive (instead of forcefully pushing everyone into it) will also make the perception of the tax regime fairer (paying a lower % of income), in addition to making it simpler. This is likely to increase compliance and reduce tax evasion.

The discussion above can be summarized by just looking at a proposed income tax slab structure - only for new regime.

Here are the outcomes we can hope to drive with a structure like this:

• Increased coverage: Start the base tax paying limit at Rs. 2 lakhs (even if at a tax rate as low as 2-3%). This will increase the tax base to more than 3x of current base
• Rationalize effective tax rates by adjusting tax slabs and tax rates
• Tax revenue neutrality & upside: While increasing the tax base, this will likely be revenue neutral for the government. Increased compliance and lower management costs are pure upside, in addition to overall rationalization of the tax regime
• No additional tax deductions / exemptions
• Consider bringing large farmers in the tax net

This brings me to the last part of my discussion - How does a government get more people to pay their taxes?

Tax compliance is significantly driven by tax morale - the intrinsic motivation of taxpayers to pay taxes. And tax morale, in turn, is driven primarily by the perceived fairness of the tax system (Source: Research quoted in Economic Survey of India, 2019).

The discussion of fairness is in the context of the perception of vertical and horizontal fairness / unfairness, i.e. how much benefit a person believes he/she gets for paying taxes (vertical fairness), and how much tax he/she believes is being paid by them vs different sections of society (horizontal fairness). Sharing a brief explainer for a quick understanding of these concepts of vertical and horizontal fairness.

Vertical fairness:

Some examples of perceived vertical unfairness - Why am I paying so much tax? Public school education continues to struggle with quality. Roads are still full of potholes. The traffic keeps getting worse. The public transport system is not efficient. The public healthcare system is virtually non-existent. The legal system is a nightmare to navigate for a lay person. The police is corrupt, etc. (Side note: The following note from the govt. in Finance Act 2022 attempts to answer the question "Why should I pay tax": Link)

Looking at tax rates from a comparison lens, though our tax rates seem to be at par with some developed economies like USA, European nations, etc, the quality of social benefits in those regimes is not comparable. Free of cost high-quality government sponsored healthcare in UK & many parts of Europe, high-quality public-school education in Nordics, excellent roads and infrastructure, etc. While our government also provides these facilities, quality is a persistent issue, with leakage of funds to corruption and mismanagement being a major problem. Thus, one possible solution (in part, atleast) may be to reduce tax rates in the new regime, while our physical and social infrastructure gets ready to justify the higher rate.

Horizontal fairness:

Some examples of perceived horizonal unfairness – Why am only I paying taxes while others are not, while still enjoying the same benefits? Salaried people often believe self-employed people do not pay as much tax. Property owners do not pay as much tax.?A small portion of India’s salaried population pays the bulk of its individual income tax (0.25% of the population pays 80% of the tax), which gets redistributed to others and doesn’t benefit the taxpayers that much. Of the total personal income declared, 60% is salary income, while only ~25% is business income (Source: LiveMint).

The continued prevalence of cash transactions in many sectors has allowed people earning business and rental income to continue to avoid paying taxes (or paying much lower taxes than their fair share). The government is making continuous efforts to formalize the economy, bring more people into the banking ecosystem and reduce the cash economy, but there is still a lot of road to cover on this front. Further, moves like expanding the ambit of presumptive taxation are well received since they reduce compliance burden on small businesses, and make it easier to comply with the laws.

The Economic Surveys in the past have highlighted some recommendations to reduce this perception of unfairness, and the government has started implementing some of them as well, to their credit - lesser intrusion, more politeness, simplification of processes, issuance of certificates of appreciation to taxpayers (silver, gold, platinum, etc.).

To conclude.?

Will the government take some of the suggestions outlined above on the way forward? Maybe, but probably not. Because doing it is not as easy as it sounds, and there are lots of other complications, considerations, and of course, interests (read: votes and notes) involved. So, the response I would expect from the govt. would be:

Hope you enjoyed reading. Do leave your views in comments.