Examining income tax announcements of Budget 2021-22 with a broader perspective, Gurbachan Singh highlights the need to increase tax collection in India in a gradual and careful but sustained manner. In his view, while checking tax evasion is important in this context, it is also important to ensure that the law requires people to pay taxes in the first place.
“In venturing suggestions on so broad a scale, an individual ... can be more radical - in the etymological sense of going to the roots of the matter - more consistent, and more venturesome” - Milton Friedman, 1959.
The 2021-22 Union Budget was presented on 1 February 2021 by Finance Minister Nirmala Sitharaman. In this post, I will consider the tax side of the budget with the following motivation. First, the focus is usually on the expenditure side with much less attention being paid to where the funds will come from. Second, the fiscal situation is not good in India. Budget estimates for 2021-22 show that only a little over half of the receipts of the central government will come from taxes; 47% comes from non-tax revenues, non-debt capital receipts, and borrowings and other liabilities. There is a clear need to raise the tax collection in India.1
Here, I will comment on the current budget, but with an eye on the long term.. Every year, most of the commentary is around what the central government has done in the budget just presented and some important issues can get left out for a long time. In this post, I seek to fill this gap.
There is much to be said on the taxation side. However, I will confine myself primarily to income tax, though I will touch upon other direct taxes to provide a broader perspective. As per the budget estimates for 2021-22, only 14% of the receipts (and 26% of the tax receipts) are constituted by income tax. There is, of course, a need to check tax evasion. But if the law only requires some to pay income tax, and none to pay wealth tax or inheritance tax, then the role of tax evasion is a bit exaggerated. Only 1% of India’s population pays income tax and declares earnings above the threshold level – but this is not just due to tax evasion.
Income threshold for tax applicability
The threshold for exemption from payment of any income tax, Rs. 5 lakh, is over 3.5 times the national per capita income, and higher than most countries. (Business Standard 2021). Unlike most previous years, there has been no further increase to this threshold in the budget, and this is a positive development.
This threshold is at the individual level, and the same is applicable to other adult members in the family who have incomes. So, if there are two adults in a family, the total potential exemption is Rs. 10 lakh annually. It is true that female labour force participation is low in India, but women’s share among tax assesses is not so low. The reason is that it is possible to ‘show’ some income in the name of the spouse, who is typically the wife in India (despite some efforts by the tax department to check this). Moreover, many families in India are effectively not nuclear families. So, besides the couple (or even the main couple) in the family, there can be other tax assesses. Hence, the total exemption for a family can be considerable. The story does not end here. If a family files taxes not just in individual names but also in the name of ‘Hindu Undivided Family’,2 then there is an additional Rs. 2.5 lakh exemption per year.
Exemptions under income tax laws
There are many exemptions under income tax laws. Let us consider one example in detail. There is a tax benefit if an investment of up to Rs. 1.5 lakh is made in Equity Linked Savings Scheme (ELSS) – an equity mutual fund with a lock-in period of three years. The assessee needs to save Rs. 1.5 lakh annually for just three years to get the exemption for the rest of their life! This is because at the end of three years, the assessee can withdraw the ELSS investment, and re-invest the funds ‘afresh’ and claim tax benefit in the fourth year as well. In the fifth year, they can withdraw the investment made in the second year, invest the funds again, and so on. This scheme is available for each family member and for the Hindu Undivided Family, potentially adding up to a large total exemption.
The ELSS exemption becomes even bigger if we take expected capital gains3 into account. If the average nominal return on the equity fund in the long run is, say, 11%, then the realisable value at the end of three years is not Rs. 1.5 lakh but roughly Rs. 2.05 lakh. So, only about 75% of the initial amount needs to be re-invested in an ELSS scheme after three years.
The ELSS exemption was conceived at a time when the stock market and mutual funds were not very popular, but the provision has remained.4 Currently, the Bombay Stock Exchange Sensex is performing rather well. So, it is not clear if such an incentive is needed now – assuming there was some valid rationale in the past, which too is doubtful.
Let us consider another important exemption related to home loans; the interest portion of the EMI (equal monthly instalment) paid for the year can be claimed as a deduction from total income, up to a maximum of Rs. 2 lakh. There are other tax benefits related to housing loans. In this budget, the additional deduction in the case of “affordable housing” has been extended until 31 March 20225 (many others are not mentioned as they are here to stay anyway). It is true that people need some relief, given the high property prices in the country. However, the appropriate way to address this is to ease, what may be called, the license-permit-quota raj in real estate development (Singh 2017) not tax exemptions.
Let me mention two more longstanding provisions under the income tax law:(i) exemption for premium paid on medical insurance policy of up to Rs. 25,000 per assessee, (ii) interest income from savings accounts in banks is exempt up to Rs. 10,000 for each assessee.
Let us now consider an example where this budget has changed a provision of the income tax law. It has been announced that senior citizens above the age of 75 need not file returns if they have only pensions and interest as income. Only an elite segment of the population gets a pension and interest income in India. So, this is an exemption for the affluent (it is a different matter that somehow too many well-off people think of themselves as ‘middle class’). It is true that the elderly need support but this sort of change in the tax law is unlikely to be a high priority for most of them.
It is interesting that when people (including many economists) think of tax exemptions, they tend to think of exemption for agricultural income. In fact, that is hardly an effective exemption, given low agricultural incomes and high threshold before income tax becomes applicable anyway. That exemption can be removed without much difficulty – alongside the removal of many other exemptions outside of agriculture.
There are some issues here. First, while it is possibly true that each of the above exemptions do not cost the central government too much, the total impact of all the different exemptions can be significant Secondly, the exemptions are availed primarily by the more-aware segments in the population, and those who are able and willing to find and pay a good tax advisor. So, it is not an egalitarian policy. Third, though there may be some similar provisions for exemptions in developed countries too, the number of exemptions is not so high.
It is important to reduce – if not remove – the various income tax exemptions in a phased manner, and alongside deal with the difficulties people face in a well-targetted way through other appropriate policies.
A policy suggestion on income tax threshold
Given that the income threshold for tax is very high relative to the national per capita income, there is a need to reduce this substantially. This will increase income tax collection. It may well be true that it is difficult to reduce the threshold in practice. However, the political or practical situation can be very different if two steps are taken. First, the reform can be brought about gradually and in a sensitive way over a period of time (Singh 2020c). For instance, the threshold may be reduced from Rs. 500,000 by just Rs. 5,000 to Rs. 495,000 in one year, then to Rs. 490,000 in two years, and to Rs. 485,000 in three years, and so on. Second, any such small change should be preceded by a massive and sustained public awareness campaign to explain the rationale for the change.
It may be argued that as the tax base widens, implementation issues can arise. Why legislate what cannot be implemented? It is indeed true that it was difficult in the past to ensure tax compliance. However, there have been considerable advances in technology over the years. Bank accounts have become very important, accounts in different banks are being linked, Aadhaar6 is being used for several purposes, credit cards are being used widely, and the need to maintain credit worthiness for loans have changed incentives for compliance with (reasonable) tax laws. So, it is far more realistic at present to reduce the income threshold for tax than it was say, 20 years ago. It is true that there have been exaggerated claims of the benefits of technology in providing various benefits (for example, PDS) and income support. However, this criticism is primarily in the context of the poor, with limited literacy and digital access. Here, the discussion is about widening the tax base from the very top segment to just a layer or two below.
As a last resort, at the very least, what can be done is to freeze the nominal value of the threshold for several years. The targeted inflation rate in India is 4%. So, in real terms, the threshold for income tax applicability can be reduced by 4% every year. Hence, in 10-years’ time, at the current price level, the threshold can be brought down from Rs. 500,000 to Rs. 332,400. At the same time, the per capita income is expected to go up significantly. This implies that the huge gap between the threshold income and the per capita income can be brought down substantially in a decade by just one simple reform of freezing the nominal threshold for a decade. Now, 10 years is a very short time in the economic history of a country. In fact, if we adopt some other policy measures considered above, then the time period for a big change can come down substantially from 10 years – and all this without raising any income tax rates.
Income tax in a broad perspective
Any change is looked at within a larger picture. It may be argued that the greater income tax collection being suggested here is in the backdrop of a big reduction in the base corporate tax rate from 30% to 22% in September 2019. Was that reduction warranted? A fall in the corporate tax rate may or may not be very useful in pushing real investment (and growth of gross domestic product (GDP)). However, investment can be sensitive to tax rates in one country relative to tax rates in other countries. So, the tax rates in India need to be somewhat ‘competitive’ internationally, given the mobility of capital.
In any case, it is interesting that even the Scandinavian countries – which have a very high tax-GDP ratio – have for long opted for ‘reasonable’ rates of corporate tax. So, a low corporate tax rate in India (lower than what it was in the past) may have a place. Of course, Scandinavian countries also have emphasis on corporate governance, audits, corporate responsibility, ease of doing business and ease of entering business, and so on. We are gradually learning more about meaningful competition between big businesses (Tepper 2018). These are the areas where we need reforms or changes in policy for the corporate sector. A rise in the corporate tax rate may be less suitable.
New US president Joe Biden had stressed on raising corporate tax rate in the US, in his election campaign. If he does that and if his decision influences other countries to raise the corporate tax rates, then the central government too should move quickly and do the same. In fact, it will help to take up the issue of corporate tax rate at an international forum like the G20 so that a coordinated stand can be taken across countries. It may further help to create a separate forum, which would function as a counterpart of the World Trade Organization (WTO), to coordinate on customs duties internationally.
All this is not to say that taxes should not be increased for the rich in India. Given the present situation in the country due to Covid-19 and the severe lockdown, there was scope in this budget for some ‘solidarity tax’ on the well-off in India. A new beginning could have been made in the form of imposition of a wealth tax and/or inheritance tax for the rich (along with some amendment to the law related to the gift tax). It is worth emphasising that such taxes are imposed even in normal times in the so-called capitalist countries, and these are not imposed in a ‘mixed’ economy like ours even in extraordinary times. Some may feel that this can adversely affect aggregate demand at this stage, but this is unlikely (Singh 2020a).
The purpose of collecting more direct taxes is not just to raise tax collection. It can also be used partially to pave the way – in a phased manner – for reduction of the goods and services tax (GST) rates, which are high in India. This may also, in part, obviate the need to further raise custom duties, which have been going up for a while now.
There is a need to increase tax collection in India – gradually and carefully, but in a sustained manner. An important way is to check evasion of all taxes. However, it is also important to ensure that the law requires people to pay taxes in the first place, this is particularly true of income tax on the one hand, and wealth and inheritance tax on the other – though the segments that need to be ‘targetted’ are very different in the two cases. Furthermore, given the imposition of a tax, there is a need to move in a phased manner to keep exemptions to the minimum, and at the same time, use other suitable policy measures to provide much-needed relief to people in different spheres of their lives.
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- This is not withstanding new work on public debt and low interest rates (Blanchard 2019); for a critique in the Indian context, see the first part of Singh (2020b).
- A Hindu Undivided Family is a family which consists of all individuals lineally descended from a common ancestor, as well as the wives and daughters of the male descendants.
- These capital gains were tax-free until recently and now taxable by 10%.
- In fact, the real value of the minimum investment required to avail tax benefits has come down on account of inflation.
- Many other tax deductions were not explicitly mentioned in the budget speech because these are intended to remain the same.
- Aadhaar or Unique Identification (UID) number is a 12-digit identification number linked to an individual’s biometrics (fingerprints, iris, and photographs), issued to Indian residents by the Unique Identification Authority of India (UIDAI) on behalf of the Government of India.
- Blanchard, Olivier (2019), “Public Debt and Low Interest Rates”, American Economic Review, 109(4): 1197-1229.
- Business Standard Editorial Comment (2021), ‘Cleaning up taxes’, Business Standard, 19 January.
- Friedman, Milton (1959), ‘A Program for Monetary Stability’, The Millar Lectures, Martino Publishing.
- Singh, Gurbachan (2017), “Land Price, Bubbles, and Permit Raj”, Review of Market Integration, 8(1&2): 1-33.
- Singh, G (2020a), ‘Covid-19: Getting the fiscal policy right’, Ideas for India, 7 May.
- Singh, G (2020b), ‘Covid-19: Does the Government of India really have limited fiscal space?’, Ideas for India, 29 May.
- Singh, G (2020c), ‘Fast pace of reforms: Right and wrong’, Business Standard, 15 December.
- Tepper, J and D Hearn (2018), The Myth of Capitalism: Monopolies and the Death of Competition, Wiley.