In my earlier article (Chinks in household finances, Businessline July 15), I had argued that the financial position of India households has weakened in the past few years. Falling labour share in India’s total GDP is a very common phenomenon; however, faster growth in household spending vis-à-vis income means that household net financial savings (HHNFS) have collapsed and their borrowings have increased rapidly. But if income growth is weak, what explains the robust growth in personal income tax (PIT) collection?
For the first time in the post-liberalisation period, personal (non-corporate) income taxes have surpassed corporation taxes in FY21 and is estimated at all-time high of 3.5 per cent of GDP in FY24P and budgeted at 3.6 per cent of GDP in FY25 (vs 2.5 per cent of GDP in the pre-Covid period).
At the same time, corporation taxes are budgeted at 3.1 per cent of GDP in FY25, compared to 3.4 per cent of GDP in the pre-pandemic years.
There are at least three possible reasons that can explain strong PIT growth amid weak growth in personal disposable income (PDI).
DDT angle
First and the primary cause is the change in the regulation regarding dividend distribution tax (DDT).
In her 2020-21 Budget speech, on the February 1, 2020, before the pandemic hit us, the Finance Minister proposed “…to remove the DDT and adopt the classical system of dividend taxation under which the companies would not be required to pay DDT. The dividend shall be taxed only in the hands of the recipients at their applicable rate…”.
It means that dividend distribution tax (DDT) ceased to exist in its erstwhile form in FY21, and was shifted from the corporation taxes into PIT. With such a shift, the tax rate on dividends was also changed from 15 per cent (plus surcharges and cess) to the personal income tax applicable to the individual taxpayer. These two related changes explain 45-75 per cent of the surge in PIT in the post-pandemic years.
In the US, as much as 87 per cent of all corporate equities and mutual fund shares were held by the top 20 per cent income earners (or 20 per cent wealthiest) in 2023. It would not be unfair to assume that the high-income earners are the primary participants in the equity market in India also, and thus, their dividend receipts would be subject to a much higher effective tax rate of 25-42 per cent.
In FY20, the last year when DDT was included under the corporation taxes, it amounted to ₹50,400 crore (or 0.3 per cent of GDP), implying total dividends paid of ₹2.9 lakh crore (or 1.4 per cent of GDP). In FY24, total dividends have likely increased to ₹5.5 lakh crore (or 1.9 per cent of GDP).
With an effective tax rate of 30 per cent, income taxes on these dividends would amount to 0.6 per cent of GDP, explaining more than half of the additional PIT receipts between FY20 and FY24P.
In reality, the actual effective tax rate would be between 25 per cent and 42 per cent, since all dividends are now either taxed at the new corporate income tax rate or the highest marginal personal income tax rate (under the old tax regime), dividend taxes could account for anywhere between half and three-fourths of the additional PIT taxes between FY20 and FY24. This factor, along with the cut in corporate income taxes in 2019, also helps explain lower corporation taxes in FY24P vs FY20, despite more than doubling of corporate profits in the past few years.
Excluding dividend taxes, thus, PIT would have mostly increased in line with nominal PDI/GDP till FY23, with a higher level only in FY24. These calculations suggest that PIT excluding dividend taxes (PIT ex DT) amounted to 2.5 per cent of GDP in FY23, same as in FY19 and FY20. Nevertheless, PIT ex DT likely surged to 3.0 per cent of GDP in FY24, which may be explained by the next two factors.
Second possible reason is related with the increased amount of activities in the financial markets. A clear evidence of that is the tripling of securities transaction taxes (STT) to ₹37,000 crore in FY25BE (or 0.11 per cent of GDP), from ₹12,400 crore (or 0.06 per cent of GDP) in FY20.
Buoyant equity markets
Besides, the surge in equity markets would have led to high profits for many shareholders, assuming they would have booked at least a portion of such profits, which would have also attracted capital gain taxes. It is impossible to come out with any sensible estimate on this; however, it is likely to have contributed decently to the surge in PIT in FY24.
Lastly, it is very likely that the high-income earners have witnessed a disproportionate growth in their income in the post-pandemic years, suggesting a possible change in the income distribution in the economy.
With the surcharges on personal income taxes ranging from 10 per cent to 37 per cent (which was reduced to 25 per cent in 2023-24 under the new tax regime) on people earning more than ₹5 crore, this shift in the income distribution towards rich people may have also contributed to higher PIT growth, amid weak aggregate PDI growth.
Overall, although PIT has seen an increase to 3.5 per cent of GDP in FY24, from 2.5 per cent in the pre-Covid years, it does not present any contradiction with weak income growth.
The following four factors explain the surge in PIT in the last few years:
(i) inclusion of taxes on dividends into PIT, from the corporation taxes;
(ii) almost doubling of the effective tax rate on dividends, which themselves have doubled;
(iii) capital market transactions (incurring STT) and capital gains taxes, and;
(iv) the unequal recovery in income growth among consumers, with the rich witnessing higher growth. Since the surcharges were increased at high-income levels, the so-called K-shaped income recovery may have also contributed to the surge in PIT, but its impact is likely to be small.
Household savings and debt will be discussed in subsequent articles.
The writer is Senior Group Vice President - Institutional Research - Economist, Motilal Oswal Financial Services Ltd