Make income taxes more equitable

Even as the Government attempts to get the wealthy to pay a fair and appropriate share of income taxes, it needs to reduce the distortion caused by deductions and exemptions allowed to individual tax payers. Reducing distortions is essential to ensure greater horizontal equity for taxpayers, that is, to ensure that people with similar income bear similar burden of taxes.

Unfortunately, India’s tax system is unfair to those with low income and little or no surplus to invest in the tax saving schemes and social security instruments. Incremental increase in rebates given to those at the borderline of the tax net and small tinkering with the income threshold subject to taxes does little to ensure horizontal equity.

Consider two individuals with similar income — say, a salary income of about ₹12 lakh per annum and some other income such as interest on bank deposits. If an individual (A) happens to be the sole earner of the household with a wife and two children while the other ( B) has no children or old parents to take care of and therefore has fewer expenses, the ability to save and invest in instruments to save tax would be vastly different.

A who has higher expenses will also usually pay higher taxes than B. This happens as A may not have enough savings to take full advantage of the deductions allowed under Section 80C of the Income Tax Act 1961 (up to ₹1.50 lakh), invest in the New Pension Scheme (₹50,000), and spend on medical insurance for his family and himself (₹25,000). In comparison, B is more likely to be in a position to take full advantage of the deductions allowed under Section 80C. That apart, B may also be in a position to avail a home loan to invest in a house and could therefore claim deduction on interest paid. Thus B can theoretically claim benefit to the extent of ₹4.44 lakh by taking advantage of all the deductions allowed under the Income Tax Act, while A may manage to avail only a fraction of those benefit.

However, there is little rationale for A being put to disadvantage vis-à-vis B. Reducing deductions will help restore some parity in the tax liability of both; complete parity and equity is impossible. However, reducing deductions without reduction in tax liability for all will lead to howls of protests from the salaried middle classes. Therefore, any move to lower deductions and rebates allowed must be accompanied by changes to threshold of income that is exempt from tax.

Currently, taxable income to the extent of ₹2.50 lakh is exempt from income tax for all individuals below the age of 60 years. For those between 60 years and 80 years, taxable income of ₹3 lakh is exempt and for those over 80 years, income of ₹5 lakh is exempt. The finance minister would do well to take a close look at the Section 80C deductions to weed out those that are more distortionary than others. Incentives for savings, particularly for social security, would need to stay to encourage people to save for their future. And, so would deductions for medical care of the critically ill given that very few have health covers or enjoy the benefits of public healthcare. At the same time, the finance minister needs to take cognisance of rising cost of living, particularly rents in cities and education costs, and increase the threshold of income subject to tax.

Consequently, he may lose some income tax revenues and have some taxpayers exit the tax net temporarily. Given that the income exempt from taxes has remained unchanged at ₹2.50 lakh since 2014-15 as well as the erosion in the buying power of the rupee due to inflation, there is a case to increase the tax threshold.

The move would lift consumer sentiments that have been depressed following demonetisation and thus help revive consumption spending. What is lost as income tax revenue for the government may be made up by indirect taxes on goods and services.

A clean-up of deductions allowed can also lower tax planning and compliance costs for individuals and employers. Those suspected of evading taxes can be tracked down if the tax authorities effectively use data mining tools, particularly information on high value consumption.

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