bBudget 2023 is round the corner, in which the central government may announce some amendments in the personal income tax regime. In the context of direct taxation in India, a neglected issue relates to the effect of inflation on income tax payments.
India, like most countries, has a progressive income tax system. The government sets progressively higher rates for each tax bracket. These are known as marginal tax rates.
Inflation is an increase in the average price level compared to the previous year. Inflation increases our tax burden. Imagine you receive a 6 percent pay raise and you move into a higher tax bracket to pay a higher tax rate on the additional income. Now suppose that inflation is also 6 per cent. In fact, your real income or your purchasing power hasn’t changed. But you’ll pay a higher income tax, and your after-tax real income will be lower. If inflation was 8%, your real income would be even less.
This phenomenon is known as ‘bracket creep’ because some taxpayers ‘creep’ into higher tax brackets even though they shouldn’t. This is also known as ‘fiscal drag’ – as taxpayers are ‘dragged’ into paying income tax at a higher rate – this enables governments to achieve faster tax revenue growth without raising tax rates.
old and new tax regime
To avoid the above situation, some countries such as the United States announce an annual inflation adjustment for tax brackets. For example, for 2023, the US Internal Revenue Service has raised Income cap 7 percent for all tax brackets as of 2022.
India currently has a dual personal income tax regime, and taxpayers are free to choose either one. Under the old regime, a taxpayer could claim several exemptions to reduce the taxable income. These include standard deductions, deductions under section 80C to encourage long-term savings, and house rent allowance, etc. Making changes to exemptions is one way governments try to manage the effects of inflation. Furthermore, under the old regime, long-term capital gains are inflation-indexed.
Under the new tax regime introduced in 2020, there are only a few exemptions, such as deduction for contribution made by an employer to the New Pension Scheme (NPS). Only minorities in the private sector can avail the NPS deduction.
The government aims to phase out the old tax regime, but before finalizing the new tax regime, there is a need to carefully relook at tax brackets and marginal tax rates keeping in mind the impact of inflation on income tax payable. The question is: Suppose a person’s income has increased only in line with inflation during the last decade, will his income tax payable under the new tax regime increase in line with inflation, more than inflation, or both at the same rate?
We illustrate this point through a simplified case of individuals with only salaried income and inflation over the past decade.
Take five persons with salaried income of Rs 4, 6, 8, 10 and 12 lakh in 2012-13. To keep it simple, let’s assume that there was no other source of income. We multiply their nominal income by average retail inflation to calculate their salary income for 2022-23. In short, we keep his real income the same in both the years.
We calculate the tax (including cess) paid by these persons in 2012-13 by applying the relevant tax brackets for that year. And we assume that the individual avails only one deduction under section 80C of Rs 1 lakh in 2012-13. Section 80C is the most commonly used deduction which encourages long term savings in pension funds, long term equity funds etc.
To calculate the tax payable in 2022-23, we apply the tax brackets and tax rates under the new income tax regime. We assume that no deduction is taken under the rule.
We find that the increase in the personal income tax burden is much greater than the increase in nominal income for all five individuals, even when their real income is the same as a decade ago (Table 1). As a result, the average tax rate, the ratio of total taxes paid to total income, is higher in 2022-23.
Inflation does not affect everyone equally, even if their incomes increase at the same rate. Our lowest five income taxpayers have been most adversely affected under the new tax regime. While the cumulative inflation was around 70 per cent between 2012-13 and 2022-23, his tax burden has more than doubled.
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Need for change in new tax system
What should be the tax brackets and marginal tax rates to offset the effect of inflation on the tax burden for these individuals with only salaried income? Our previous calculations suggest three changes to the current new tax regime to offset the impact of inflation on the average tax rate over the past decade (Table 1 – Row – 2022-23 Revised Tax Regime). This will also make the tax system easier.
First, no tax should be paid between Rs 2.5 lakh to Rs 5 lakh if the gross income is more than Rs 5 lakh. Second, there should be only four tax brackets (Table 2). Finally, the highest marginal tax rate is 25 percent, compared to the current 30 percent.
We emphasize that these calculations are for illustrative purposes only and for a simple case where there is only salaried income. If income rises in line with inflation, a sophisticated modeling exercise will reveal the most appropriate tax brackets and rates to keep the average tax burden the same. Inflation indexation for tax brackets should happen every year once the government finalizes the appropriate brackets and rates.
Restructuring tax brackets, tax rates and annual inflation indexation has implications for government finances. But, it would be a better system for the taxpayers. To offset tax buoyancy and any negative impact on tax revenue, we need to expand our tax base—the number of people who pay income tax.
The intention of the government is to make the income tax system fair. It would be worthwhile to consider improving the new tax system.
Knowledge Mahambare is Professor of Economics and Director (Research) at Great Lakes Institute of Management, Chennai. She tweets @mahambare_vidya. Praveen Kumar is a graduate of Great Lakes Institute of Management. Thoughts are personal.
(Edited by Ratan Priya)