India's Income Tax Rates May Be Cut, But What Reforms Should Accompany Them?

As per a recent leaked internal assessment on revenue projections for FY’20, the Narendra Modi government is likely to fall short of its fiscal budgetary estimate by at least Rs 2 trillion.

This was reportedly part of a communication between the Ministry of Finance and the 15th Finance Commission, after the latter requested the former for a revised update on its fiscal earnings, considering a chronic economic slowdown may impact the fiscal landscape .

India’s gross tax to GDP ratio has already dipped to 10.9% in FY’19, as both indirect and direct tax revenues ‘slipped’ by a significant margin last year. The same pattern seems visible now, and with the recent corporate tax break, this may get worse — a ‘fiscal slippage’ graduating into a straight-up fiscal heart-attack.

In fact, right after the corporate tax cut, the finance ministry estimated an accrued loss of Rs 1.45 trillion for this year itself. This,in addition to how volatile the GST revenue margins have been since its inception, has coincided with the government’s ability to widen the direct income tax base with limited success.

It was earlier argued, in a previous part to this article, how India’s overall tax structure, in its current form, is increasingly making it difficult for the Union government to manage its own fiscal plans, and this may negatively affect its welfare expenditure allocations for now and in years to come.

Also read: Full Tax Rebate for Income Up to Rs 5 lakh

And this seems to be happening at a time when, given an increasing centralisation of both economic and political power, the Union-State revenue sharing relationship is being altered too. Where a gradual reverse in devolution of funds is realisable (from State-to-Centre), allowing the Centre to enjoy greater control and autonomy, and subsequently increase its allocations for defence and other intended purposes.

Considering these scenarios, there are some critical fiscal steps that the finance ministry can consider to avoid a burgeoning fiscal deficit.

In the the short term

Even though the Centre faces a slowdown exacerbated by fall of aggregate demand in consumption, it may be prudent to avoid making any drastic changes to its income tax slabs for at least another fiscal year at least.

It has already made drastic cuts to the corporate tax rates, which as a supply-side measure, will do very little in either increasing new investments in the short-term (in order to boost consumption or demand). If, as widely speculated, similar changes were to be made in the income tax bracket, we would see a further fall in the direct-tax-to-GDP ratio.

If we look at the data on direct tax collections, the average direct tax collected since 2009-10 has remained around 55% of the total tax collections, with 2010 showing the highest proportion of direct tax collected (at 61%). In 2018-19, this was 52%.

Within the direct tax structure, revenue collected from corporate tax has been falling — from 63% in 2009 to 56% in 2018. It has principally been personal income tax that has provided a more stable source of direct tax income to the government — i.e. from 35% to 41% in the same period.

It is imperative that the government ensures that it continues to widen its personal income tax base without altering the slab structure too much over the next few months. This is also critical because a volatile (or weak) direct tax-GDP ratio has a significant effect on nominal growth levels (and vice-versa).

And in India’s rapidly expanding middle-income groups, there is already a fundamental tax problem- termed as the ‘missing middle’, where those (working in services of CA, lawyers, doctors) are able to craftily evade tax even if their taxable incomes are going up.

So, maintaining a stable direct tax-to-GDP ratio and widening the tax base should be the main short-term goal.

Structural alterations in the medium to long term

In the medium term though, over the next 24 months, if incomes of salaried groups rise, there is a strong case to be made for the government to make adjustments to its personal income tax structure. But these changes should be made in a way that overall revenue margins are least affected while the direct tax-base can continue to further widen; bringing new taxpayers into the bracket.

As most within higher middle income categories initially pay a 30% tax for income at Rs 10 lakh (per annum) and more, there is an argument to made in favour for widening the 20% tax slab to this income group too (those earning up to Rs 10-12 lakh) and enable them with more disposable income.

This would help in boosting consumption and increasing household savings or financial investments. Another possibility is to sub-categorise two income groups, to slice the 30% income tax slab.

Similarly, for deductions, the exemption limit can easily be raised up to Rs 4 lakh or Rs 4.5 lakh say, with higher limits on PPF, LIC, NSC under Section 80(c)) primarily to boost financial savings for households, which have otherwise been declining over the last few years. Low household savings with the financial sector adversely affects the financial institution’s ability to exercise better credit creation powers and boost investment sourced from domestic means.

Also, looking at the rise in personal cost of living for (higher) middle income groups, a higher exemption limit may help boost long term savings towards retirement or increase investments in private pension funds.

Assuming India is able to enhance its direct income tax collections vis-a-vis indirect tax collections – if GST sourced revenues stabilise over a period of time – there is scope for at least two structural alterations to be made in the economy’s overall tax framework.

These emerge from trends seen in the charts given below.

Figure 1: Income and Wealth Inequality in India 1922-2015

Figure 2: Net National Wealth to Net National Income Ratio in India 1860-2012

The two charts above illustrate the widening of growth-differentials between ‘income’ and ‘wealth’ accumulation in India. The distinct difference between the top 1% and top 10% wealth share vis-a-vis the top 1% and top 10% pre-tax income share provide a base for the government to argue for a progressive wealth tax.

The first structural alteration therefore, could be in form of re-introducing a progressive wealth tax to address systemic wealth inequities entrenched within the Indian economic landscape. While the 1957 Act allowed for a 1% wealth tax in India, it was during the Budget of 2015-16, when former Finance Minister Arun Jaitley abolished this tax, saying that this would be compensated by the levy of additional surcharge on high income earning assessees. Simply looking at the wealth to income ratio levels, there is a clear possibility to reintroduce this again.

The second structural alteration, and one discussed here, is to shift the focus of taxation from an ‘income-based’ idea to a ‘consumption-based’ one. This could be drawn out under a progressive consumption tax to accrue higher revenue from high, conspicuous consuming groups.

As argued, a consumption tax would be seen as a tax imposed on high-end (luxurious) consumption, as opposed to some other measure of ability to pay, most notably income, and in a large unorganised business driven economy like India -where the proportion of indirect taxes have remained high, it is possible to also measure consumption more easily than income alone.

In this way, a conscious strategy to develop a robust, optimal tax-structure in India, conceptualising a progressive tax mechanism for higher wealth and consumption classes in the medium to long term, and measures to widen the personal income tax margin by re-structuring tax slab bases (and exemption limits), can go a long way in ensuring tax buoyancy and a path towards fiscal consolidation.

Deepanshu Mohan is Associate Professor of Economics at O.P. Jindal Global University. He is a Visiting Professor to the Department of Economics at Carleton University (Ottawa).