The tax rebate proposal promotes inequity

In the interim Budget the Finance Minister proposed to provide full tax rebate up to ₹12,500 to individuals with net taxable income up to ₹5 lakh, under the provisions laid out in Section 87A of the Income Tax Act, 1961.

Being a rebate, and not an exemption, the proposal means that individual assessees with net taxable income above ₹5 lakh will be unable to claim any rebate, and shall be required to pay tax at old rates on income above ₹2.5 lakh.

No changes were announced in the prevailing income tax slabs and corresponding income tax rates, which are as follows — nil taxes for income up to ₹2.5 lakh; 5 per cent tax on net taxable income between ₹2.5 lakh and ₹5 lakh; 20 per cent tax on net taxable income between ₹5 lakh and ₹10 lakh; and 30 per cent tax on net taxable income above ₹10 lakh.

The proposed changes were greeted enthusiastically by Parliament, and by experts in TV studios hailing this as an unassailable pitch to ensure electoral fortunes in the upcoming general elections for the incumbent NDA government.

But for a nuanced understanding, we need to examine the proposal a bit more critically. In his Budget speech, the Finance Minister reported that the proposed tax rebate would benefit three crore individual taxpayers, costing ₹18,500 crore to the government exchequer. This translates to an average relief of ₹6,166 per individual assessee in a year, not a substantive amount. The full benefit of the rebate, ₹12,500 will only accrue to individuals with net earnings at the upper limit (i.e. ₹5,00,000).

A more serious concern about the proposal involves its equity aspect. A taxpayer, with a net taxable income slightly above ₹5 lakh, will end up paying ₹13,000 (including 4 per cent cess as currently applicable) in addition to 20 per cent of the amount (plus cess) by which her income exceeds ₹5 lakh. A simple calculation, as provided in the table below, reveals that a person with net taxable income between ₹5,00,001 and ₹5,16,414 will end up paying a tax of ₹13,000 to ₹16,414.

This will result in a drop in their disposable income below ₹5 lakh. Thus, they will not be equitably treated under the proposed changes in tax laws.

According to CBDT data for Assessment Year 2017-18, 23.60 lakh taxpayers reported gross income between ₹5 lakh and ₹5.5 lakh, while 87.64 lakh taxpayers reported gross income between ₹5.5 lakh and ₹9.5 lakh. From the data and overall distribution of gross income, as reported, we estimate that around 3.6 lakh to 5.7 lakh taxpayers (representing on average 1 per cent of total returns filed, and 1.75 per cent of total taxpayers) will be inequitably treated as per the Budget proposal.

On the positive side, the proposed rebate might incentivise individuals who fall under the gross taxable income bracket of ₹5 lakh to ₹6.5 lakh to invest in tax saving instruments. This, in turn, might help improve the dwindling gross savings rate of the economy.

However, the unequal treatment may also nudge the affected taxpayers to manipulate their income or claim inflated deductions to bring their net taxable income below ₹5 lakh. While state-of-the-art monitoring systems of the tax authorities may successfully detect such fraudulent returns, prosecution and collection will come at a considerably high administrative cost. The net benefits, therefore, remain uncertain.

A possible solution

In the light of the above discussion, it is imperative that some adjustments be made in favour of the affected taxpayers. The most equitable solution will demand a continuously-progressive taxation structure, which arguably is untenable in practice due to its inherent complexity.

There is one possible solution to arrive at an acceptably equitable treatment for persons with net taxable income marginally higher than ₹5 lakh.

If the calculated tax amount as per current slab rules is ₹T, and the amount by which the net taxable income exceeds ₹5 lakh is ₹X, then the applicable tax amount should be the minimum of the two, i.e. T and X. For example, from the above table, if a person with net taxable income of ₹5,10,000 calculates her total tax as ₹15,080, she would actually need to pay ₹10,000 as a tax to bring her disposable income up to ₹5,00,000, ensuring parity in the tax treatment.

Design of taxation structures is key for attaining the fiscal objectives of the government. An inherently inequitable tax structure, as will be the case with enactment of the proposed tax rebate, will do little to promote compliance or to expand the tax base.

We hope that this anomaly is corrected in the general Budget, and tax structures are aligned in line with the reforms suggested in the Direct Tax Code, to be presented in the near future.

Kundu is Assistant Professor, Accounting & Finance Area, and Nandy is Assistant Professor, Economics Area, at the Indian Institute of Management, Ranchi