In gratitude for the valuable contribution made by taxpayers to nation building, small and middle income taxpayers were offered a tax break in the interim budget 2019.

It is proposed that taxpayers with incomes less than or equal to ₹5,00,000 will not have to pay any tax. Such relief to taxpayers is not unique for the Indian tax system, where the exemption threshold as well as savings exemptions have been frequently revised.

However, on the occasion of another proposed tax break, it is important to seek the economic rationale of such benefit. That is, who does the policy maker seek to shield from the incidence of direct taxation. Between the beginning of 2000s and now — in a span of 17 years the exemption threshold has been revised upwards six times.

A tax break in the form of an exemption can be argued as necessary for those earning incomes that are low, in comparison to some identified benchmark.

The tax break would provide relief to such individuals so that they may meet the necessary living expenses without the burden of taxation.

Once such a benchmark, i.e., the estimated exemption threshold based on some criteria, is identified, it is important to know how the benchmark should be revised year-on-year.

Criterion for benchmark

If the identified benchmark is taken to represent a reasonable minimum income to sustain a family, then to keep this level unaltered, the benchmark needs to be corrected for any changes in prices, i.e., for inflation. Alternatively, if the government seeks to assure a stable relative income — relative to say the per capita income of the country, the benchmark income could be adjusted upwards by the rate of growth of per capita nominal income.

In other words, the ratio of the benchmark income to per capita income can be kept stable. In the former case, with increase in incomes over time, the fraction of people above the exemption threshold, i.e., the fraction of people liable to pay tax can be expected to increase.

In the latter case however, since income distribution is a right skewed distribution, which has a median lower than the mean, using per capita income and multiples of it would exclude more than 50 per cent of the income earners from taxation and will continue to do so over time. To examine how the revisions of the exemption threshold have behaved, three kinds of benchmarks are selected.

First, assuming the exemption threshold seeks to protect a predefined real income, the nominal income equivalent to this real income can be derived by correcting for inflation in subsequent years. For this exercise, three alternative scenarios are considered for the benchmark income: the actual exemption threshold fixed in 1970-71, 2000-01 and 2005-06.

To derive the inflation adjusted equivalent exemption threshold for subsequent years the consumer price inflation is used.

Second, since the rationale for the exemption threshold chosen for different years is never spelt out, poverty line or some pre-determined multiple of it can be one benchmark.

Finally, given the argument against relative income, per capita income is the third benchmark considered.

The figure shows these benchmark incomes juxtaposed against the exemption threshold for each year. Note that for all such benchmarks, except for the 2004-05 exemption threshold adjusted for inflation, the actual threshold exceeds the estimated threshold. This makes the case for providing an explicit rationale for fixing of the exemption threshold or raising the threshold.

Reduced number of taxpayers

An increase in the exemption threshold is expected to result in a decline in the number of taxpayers. To assess the likely reduction, one can use the distribution of returns by income category published by the Income Tax Department.

 

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The table shows the share of taxpayers who report returned income below ₹5 lakh. For the Assessment year 2017-18, 77 per cent of the returns showed returned income of below ₹5 lakh while 66 per cent show gross income of less than ₹5 lakh. While taxpayers with income between ₹2.5 lakh and ₹5 lakh are expected to file a return, they have nil tax liability. In other words, with the proposed tax structure, over 70 per cent of the taxpayers will have zero tax liability. With zero-liability, the need to file a return or to follow up on non-filers is reduced.

Thus, the change in the tax structure doesn’t support expansion in the number of taxpayers in the income tax regime.

The rationale

Raising an exemption threshold is presented as an effort to provide certain benefits to the taxpayers. From the figures reported for 2017-18, returns with income between ₹2.5 lakh and ₹5 lakh account for 20 per cent of total gross income and 27 per cent of returned income. In other words, these changes affect considerable amount of the incomes reported for tax purposes.

The benefits however are considerably lower since the statutory tax rate for this range of incomes is only 10 per cent. Table 2 provides a sense of the extent of benefits provided by way of the new rebate. It is interesting to note that the benefit as a percentage of income is a maximum of 2.36 per cent for incomes between ₹4.5 and ₹5 lakh. It is important to ask whether this is a high tax liability which cannot be borne. Reduction in the tax liability reduces the number of citizens contributing taxes to “nation building”.

The taxpayers’ contribution to nation building must be rewarded through appropriate fiscal exchange. That is, the quality of public goods and services must be improved. Instead a rebate such as that offered in interim budget takes away from the taxpayer an opportunity to hold the government accountable for essential services.

The writers are with National Institute of Public Finance and Policy

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