Income Tax

Every seasoned chief executive understands the basic calculus of pricing. Charge too much and customers scamper. Charge too little and the business becomes unviable. The clever bit lies in finding a price that attracts the largest possible market, while still producing enough revenue. India’s income tax system may have got this balance wrong. It resembles a company that charges a relatively high price to a remarkably small number of customers, while allowing almost the entire market to remain outside its distribution network. Those who pay complain that they are being hammered. Those who do not pay have little reason to enter the system. The government, meanwhile, keeps returning to the same narrow group whenever it needs more money. This can’t be right.

The numbers are appalling. Around 7.5 crore individuals filed income tax returns in the most detailed recent official dataset. Yet only about 2.8 crore of them reported a positive income tax liability. That means barely 2 per cent of India’s population filed an individual return on which tax was actually payable. There are, naturally, other people from whom tax is deducted even though they do not file returns. Companies, partnerships and other entities also pay direct taxes. But the key argument remains difficult to dispute. India has an extraordinarily narrow personal income tax base. Oddly, this does not mean that India collects very little direct tax by emerging market standards. Net direct tax collections are now around 6.8 per cent of GDP. This is higher than the comparable figure for China and Indonesia and broadly respectable among developing economies. It remains well below the levels found in the United States, Britain, Germany and South Africa, but India is hardly an international disaster. Its problem is not simply how much it collects but how the money is collected.

A tiny proportion of citizens carries a substantial burden, while most Indians have no direct financial relationship with the state. They certainly pay tax. GST is embedded in soap, clothing, restaurant bills, insurance premiums and almost everything else they consume. But because this money disappears into the price, most people do not consider themselves taxpayers. Consequently, they do not always connect public expenditure with their own money. A road may be poorly built, a municipal service may not work and a government department may waste funds without producing the same anger that would arise if every citizen had written an annual cheque to the state. What if India were to reverse the model?

Imagine a system in which almost every citizen with an income filed a return and paid something, even if the amount were modest. Someone earning Rs 1 Lac a year might pay 1 per cent. Income between Rs 1 Lac and Rs 5 Lac might be taxed at 3 per cent. The rate could rise to 6 per cent between Rs 5 Lac and Rs 10 Lac, 9 per cent between Rs 10 Lac and Rs 20 Lac, 12 per cent between Rs 20 Lac and Rs 50 Lac, 15 per cent between Rs 50 Lac and Rs 1 crore, and reach a maximum marginal rate of 18 per cent thereafter. The rates would, naturally, be marginal. Someone earning Rs 10 Lac would not pay 6 per cent on the entire amount. The tax would be calculated progressively across the slabs. The burden on lower and middle income earners would remain modest, while even the highest marginal rate would be dramatically below present levels. The bargain would be straightforward. Lower rates, almost no exemptions, effortless filing and very difficult evasion.

The obvious question is whether the arithmetic works. The answer depends entirely on how broadly the system is applied. If these rates are imposed only on those who already file returns, collections fall sharply. There are simply too few people in the present system to support such low rates. But suppose instead that 80 per cent of all Indians earning more than approximately Rs 1 Lac a year enter the tax system and pay what is due. Available income distribution estimates suggest that roughly half of India’s adult population earns more than around Rs 1 Lac annually. India has approximately 92 crore adults. Eighty per cent compliance among those above the threshold would therefore produce a personal taxpayer base of nearly 37 crore people. That would be a staggering expansion from the fewer than three crore individual filers currently showing positive tax liability.

When the original progressive structure, culminating in a highest marginal rate of 18 per cent, is applied to this much wider population and its estimated income distribution, it produces approximately Rs 7.95 Lac crore. Existing individual income tax liability in the comparable official dataset was about Rs 6.77 Lac crore. The 18 per cent structure would therefore collect around Rs 1.18 Lac crore more than required for revenue neutrality. That is the important result. The model does not begin with a 15 per cent ceiling. It begins by testing an 18 per cent ceiling. Only after that rate produces more revenue than the present system do the rates fall further.

Reducing every rate proportionately produces a mathematically revenue-neutral highest marginal rate of approximately 15.3 per cent. A cleaner practical structure could consequently begin at 1 per cent, rise through approximately 2.5, 5, 7.5, 10 and 12.5 per cent, and reach a maximum of 15 per cent above Rs 1 crore. Such a system would produce approximately Rs 6.7 Lac crore, almost matching present individual income tax revenues. There is, however, an important qualification. National income is not identical to taxable personal income. Some income belongs to companies, institutions or government. Some consists of retained profits or imputed income that cannot simply be placed on an individual tax return.

The estimate of nearly 37 crore potential taxpayers must also be treated as a scenario, not a tally. India does not yet possess a complete annual database identifying the income of every adult. The calculation uses the best available estimates of the distribution of national income and applies them to the proposed tax structure. Allowing for these limitations, the prudent policy conclusion is that the revenue-neutral highest marginal rate probably lies between 15 and 18 per cent. Fifteen per cent represents the theoretical result if almost the entire relevant personal income base becomes taxable. Eighteen per cent provides a margin for income that may be difficult to attribute, declare or collect.

Your columnist’s original instinct may therefore have been less fiscally demented than it first appeared. The arithmetic can work, but only if India converts income tax from an exclusive club into a genuine mass market product. This is where the corporate analogy becomes useful. A company cannot cut its prices and merely hope that volumes will eventually rise. It needs distribution, customer identification, automated billing and reliable collection. The product must be easy to purchase. Discounts cannot become so generous that nobody pays the published price. The government faces precisely the same challenge. Every taxpayer should receive a prefilled return containing salary, interest, professional receipts, rental income, investment gains and substantial business transactions. For the ordinary citizen, filing should take no more than a few minutes. Tax could be deducted automatically in small instalments throughout the year rather than arriving as one unpleasant demand.

Exemptions and special deductions would preferably have to be abolished or sharply reduced. Otherwise, India would merely combine low rates with an even smaller taxable base. Similar forms of income would also need similar treatment. Without this, high earners would resort to tricks and convert salaries and professional income into capital gains, partnership income, dividends or retained company profits. Enforcement would need to be even handed. A low rate system cannot survive if blatant evasion continues among property owners, self-employed professionals, traders or politically protected groups. Genuine agricultural income could remain protected, but implausibly large agricultural income claims deserve scrutiny. Digital payments, securities transactions, property registrations and business invoices already leave extensive trails. The state increasingly possesses the information. What it needs to fix is a simple and consistent way of using it.

The purpose of asking someone earning Rs 1 Lac to pay Rs 1,000 is not primarily to fill the treasury. Such contributions will not transform public finances. Their importance is institutional. Filing a return creates a financial identity, documents income, assists access to formal credit and places the citizen in a more direct relationship with the government. Lower rates could also leave households with more disposable income. Lower and middle income families are likely to spend much of it, supporting consumption. Wealthier households are more likely to save it, potentially adding to the pool of capital available for investment. This matters because household savings have historically provided an important prop for Indian capital formation.

India does not merely need more taxpayers. It also needs a different relationship between the taxpayer and the state. Almost everyone who earns should file. Almost everyone above a genuine subsistence level should contribute something. Nobody should feel that success is punished through excessive rates and nobody should believe that evasion is a permanent entitlement. A mass market tax system will not emerge by hammering the existing taxpayer harder. It will emerge when the price of compliance falls, the cost of evasion rises and millions of Indians begin to see themselves not merely as recipients of government services, but as citizens who helped pay for them.