Indexing tax slabs to inflation is a fair way to treat tax payers

tax

CII’s president Sanjiv Puri has suggested tax relief for assesses in the lowest personal income tax slab. The underlying logic is that it would partially neutralise the impact of inflation over the recent past. The economic benefit of tax relief is expected to translate into a higher level of consumption.

Basic economic logic suggests that assesses whose income is restricted to the lowest slab, Rs 2.5 lakh to Rs 5 lakh, are more likely to channel most of an increase in disposable income to consumption. That’s a sound reason to advocate this measure when the growth in private consumption lags the overall GDP growth.

But should this be an arbitrary move? Something that is left to the wish of the finance minister of the day?

Inflation and Indexation

Let’s keep in mind the threshold of taxation under the old regime starts just above Rs 2.5 lakh, and that’s where it has been for a few years. During that phase, retail inflation has effectively reduced the threshold at which assesses have entered tax bracket. This, in turn, would have reduced disposable income at lower and lower income levels.

One way of getting past this is to index tax slabs to inflation. That way, if a budget sets Rs 2.5 lakh as a fair threshold to bring assesses into the tax net, it will automatically account for inflation’s erosion of the value of money.

International Experience Shows A Puzzling Trend

IMF in December studied the inclination of countries to index both transfer payments to citizens and income tax. The paper, ‘Inflation Indexation in Public Finances’, found that there’s a fairly strong tendency to index payments such as pensions to inflation. However, when it came to income tax, most countries prefer to avoid a legal mandate to index.

In the sample of 173 countries, only 18 automatically adjust their thresholds. Another 16 adjust it through an unclear process. Barely 20 percent of the countries in sample are fair to their tax payers by indexing tax slabs to inflation.

Give Tax Payers A Break

Income tax has emerged as the union government’s most important source of tax revenue. In the interim budget, income tax in 2024-25 was estimated to reach Rs 11.56 trillion, or 30 percent of gross tax revenues. In terms of contribution to the overall tax revenue, it’s more important than corporate tax and GST. Moreover, a part of the income tax collected by the centre is shared with states according to the prevailing Finance Commission formula.

The least that tax payers deserve is an automatic adjustment in slabs which is in sync with a chosen inflation rate.