Do Indians have the potential to pay more tax? Most individual taxpayers will respond with a vehement ‘No’. But the Finance Minister is quite convinced that there’s room to collect more. Recently pointing out that India is still “far from being a tax compliant society” he noted that the tax-to-GDP ratio is low, and there’s room to bump it up by another 1.5 percentage points.

So, why is there such a sharp dichotomy between the perception of citizens — who feel they are taxed at every turn, and the government — which thinks that there’s room to extract more? The answer could lie in the flawed measurement of tax compliance.

Liable to tax?

The metric that is often used to drive home the poor culture of compliance in India, is the small proportion of population paying direct taxes. In FY18, 6.84 crore entities (individuals, HUFs and businesses) filed their Income Tax Returns.

Of these, there were about 6 crore individual assessees.

A straightforward comparison of this number with the population estimate (132 crore) suggests that only 4.5 per cent of Indians pay income tax.

But that’s a flawed comparison because an individual can be said to ‘evading’ income tax only if he is liable to pay it in the first place. Therefore, the most important step to assessing actual tax compliance in India, is to estimate the proportion of the population that is liable to pay income tax.

Agriculture factor

To begin with, tax liability is dependent on the age and employment status of the individual. As per the last Census (2011), only about half of India’s population fell in the working age group of 20- to 59-year olds.

Only half of this working-age population in turn, was employed throughout the year (what the Census calls Main Workers). Now, applying this to the current population count of 132 crore, there would be 33 crore individuals who earn a regular salary or wage, and can be realistically expected to pay income tax on it.

But then, Indian tax laws offer a complete exemption to one large category of wage-earners — those earning their daily bread from agriculture.

Now, Census data tell us that roughly half of the main workers were either cultivators or agricultural labourers. That immediately puts about 16.5 crore of those 33 crore main workers out of the tax net, leaving the taxable population at 16.5 crore.

Of that, 4.3 crore individuals already filed their I-T returns for salary income in assessment year 2016. In effect, at least a fourth of the wage-earners are already in the tax net.

Low income levels

Then there’s the question of how many workers or self-employed folk earn an income that falls within the taxable income slabs. We all know that India’s slab system exempts the first ₹2.5 lakh of annual income (from all sources — salary, property, business, profession and others) from tax.

Census data unfortunately does not provide the income distribution of Indian citizens. But the Labour Bureau’s Annual Employment-Unemployment Surveys do provide anecdotal evidence on the income levels for a large sampling of Indian households. The latest such survey in FY16 covered 1.5 lakh households. It found that over 87 per cent of the households earned less than ₹20,000 a month (₹2.4 lakh a year). This included full-time workers, part-time ones, casual workers, as well as the self-employed. This effectively means that only 13 per cent of the 25 crore Indian households (about 3.2 crore households), may be earning enough to pay income tax.

If income tax collections are held back by low income levels, corporate tax collections in India seem to be afflicted by the poor scale and low profits reported by the vast majority of businesses. In India, business is dominated by the 6.3 crore unincorporated enterprises that are mostly run from home. Registered companies number just 17 lakh. Of the registered companies, only about 11 lakh are active and about 7 lakh companies filed their I-T returns in FY17. But again, as many as 5.3 lakh of those companies reported an annual income of less than ₹2.5 lakh!

The above data also explain why, as the taxman has trained his guns on evaders in the last three years — tracking down non-filers and issuing a flurry of notices — he has mostly netted only small fish. Between FY14 and FY18, India saw the number of I-T return filers expand by 80 per cent from 3.79 crore to 6.84 crore. But the direct tax kitty grew by a far lower 55 per cent. Nearly a fourth of the current return filers fall in the zero-tax bracket.

Expanding the net

Yes, the above calculations are ballpark because they are based on the data available in the public domain. But what they do suggest is that the deliberate tax evasion may not be the biggest cause of India’s low tax mop-up, as the government believes. Going by the number of taxpayers, at 6.84 crore, the direct tax base is already at pretty healthy levels once we account for legitimate exemptions. That the tax-GDP ratio remains modest despite this, suggests that tax collections remain poor due to low household income levels and the lack of formalisation of businesses.

This has lessons for policy-makers. If they are keen to cast the tax net wider, identifying the non-filers and peppering them with notices may no longer yield material results. Instead, expanding the tax net may now require biting the bullet on taxing agricultural income, or sweeping those earning less than ₹2.5 lakh into the income tax slabs. But these moves would be political suicide, especially in a pre-election year.

Therefore, if he is still keen to improve the tax-GDP ratio, the Finance Minister may have no other option now but to stick to slow-and-steady methods to improve income levels, whether for individuals or firms.

Pushing hard at sustaining the ongoing economic revival, creating more formal sector jobs and formalising small businesses through GST-like reforms, may be the best way forward.