The India Fix: Why does such a small number of Indians pay income tax?

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Last fortnight was characterised by the rush and bustle that routinely accompanies the income tax returns deadline. For the India Fix readers, it might have seemed like the entire country was filing their returns. But peer groups are a poor way to sample data. Numbers released by the Union Ministry of Finance, in fact, show that by July 31, the due date for salaried taxpayers and others who are not required to have their accounts audited, only 5.83 crore returns were filed.

That’s a little more than 4% of India’s population. This 5.83 crore number will go up by a bit as small sections of the income tax-paying population do not fall under the July 31 deadline. But overall, the upshot will be the same: the proportion of Indians who pay direct taxes is incredibly small. In fact, as the Union Finance Minister told Parliament in March, adding up both individuals and corporations, India has just a little over 8 crore direct tax payers.

Direct taxes are charged on income and profits. They are paid directly to the government. Indirect taxes, on the other hand, are paid on goods and services, and are usually collected by an intermediary.

Tax net

It is often claimed that India does not collect enough direct taxes. This is, actually, not true. It is an error that arises from the erroneous habit of comparing the country to the industrialised nations of the West, even though India is much poorer. If we do an apples-to-apples comparison, India’s direct taxation receipts are what could be expected for a country of its per-capita income level.

Where India is really a puzzle is the number of people who pay income tax. The Economic Survey, 2015-’16 argues that for a democracy, India’s direct taxation net is rather small: only 4% of Indians pay income tax but the survey models that the number should actually be six times higher, at 23%.

This low number is a stark indictment of both India’s economy and its politics. For one, in spite of being a very large economy, India is not industrialised. Its large economic size is simply the result of its large population. As economists Thomas Piketty and Nancy Qian explain in a 2009 paper, “One reason why India faces more difficulties than China in making its income tax a mass tax might be that the proportion of formal wage earners in the labour force is ridiculously low.”

Falling behind

The paper compares India and China to show just how bad India’s performance has been. Till 1993, in fact, India had more income taxpayers than China given “the Indian income tax is a much older institution, since it was created in 1922 by the British”.

However, since then, the situation has completely reversed: “income tax has become a mass tax in China, while it has remained an elite tax in India”.

(This coincides almost exactly with the period of India’s liberal reforms, pointing to the fact that they might have been remarkable for India, but fall significantly short of what has been achieved in East and Southeast Asia.)

White collar capture

However, the economy is only one part of the picture. India’s political structure, where white-collar workers (contrary to self-perception) enjoy disportionate lobbying power with policy makers, has also played a part. The Indian government’s policies exempt many relatively wealthy Indians from paying income tax.

In fact, Piketty and Qian identify is as the primary reason for India’s poor income tax base:

“Most importantly, the tax schedule has been changed almost constantly in India during the 1986-2008 period, with a general decline in tax rates and a continuous increase in the exemption threshold and income brackets. In effect, the rise in the exemption threshold (from Rs 15,000 in 1986 to Rs 150,000 in 2008) has been almost as large as the rise in nominal income growth (from Rs 4,400 to Rs 56,300 for average income and from Rs 14,400 to Rs 192,400 for the P99 threshold).”

The tax rate refers to the percentage at which an individual or corporation is taxed.

Under Narendra Modi, whose Bharatiya Janata Party government enjoys strong support from members of the upper castes (and hence white collar workers), this trend has got reinforced. In the run-up to the 2019 Lok Sabha elections, his government exempted incomes up to Rs 5 lakh per annum from paying any tax – up from Rs 2.5 lakh.

This is not only bad for government revenues, it is simply unfair because it then forces the state to look to regressive taxes like the goods and services tax to make up for lost income. In effect, a blue-collar worker below the poverty line ends up paying high taxes on everyday items like food and clothing so that a relatively well-off urban office worker does not have to pay income tax.

It is also bad for democratic policy making if something as critical as state revenue is dependent on a small number of individuals (and corporations). A broader base would give politicians more freedom to design effective policies.

Finally, this low tax base is both a symptom of and a factor in the low faith Indians display in the state. To fix this, more Indians need to be bought into the tax net – even at low rates, if need be initially.