Macro Economy

Decoding India’s Low Tax Base Conundrum

Praveen Chakravarty
October 03, 2017

Decoding India’s Low Tax Base Conundrum

“We are largely a tax non-compliant society” declared Finance Minister Arun Jaitley during his recent Union Budget speech. He was alluding to information released recently by the Income Tax Department that shows, of the 3.6 crore people that filed tax returns, nearly 1 crore reported an income less than the income tax exemption threshold of Rs 2.5 lakh. The Economy Survey produced by Chief Economic Adviser Arvind Subramanian substantiated this further to show that India has only seven income taxpayers for every 100 voters, among the lowest of all G20 democracies.

That, less than 3 percent of Indians pay income taxes is established wisdom. Extrapolating from this, the growing narrative is that most Indians avoid paying taxes and have accumulated vast amounts of tax avoided black money. Except, a large majority of Indians are legally exempt from paying income taxes anyways!

India is an extremely poor country with a per capita GDP of Rs 1,05,815, i.e. the average Indian earns roughly Rs 1 lakh per year. The exemption threshold for paying income tax in India is Rs 2.5 lakh. Which means people earning below Rs 2.5 lakh need not pay any income tax.

This exemption threshold is nearly 2.5 times the average annual income of an Indian, and is one of the highest in the world.

When the average Indian earns a meagre Rs 1 lakh per year, an income tax exemption limit of Rs 2.5 lakh automatically removes a sizeable majority of Indians from the requirement to pay income tax. Recent research by the People Research on India’s Consumer Economy (PRICE), corroborated by National Sample Survey Organisation (NSSO) surveys, shows that the average income of the richest 20 percent of Indians is a mere Rs 95,000.

This means that even a large majority of the richest 20 percent of Indians are outside the income tax ambit.

Why is it then a big surprise that a mere 3 percent of Indians file income tax returns?

On the ratio of per capita GDP to income tax exemption threshold, India is a complete outlier in the world. The average ratio across 20 developed and developing countries is 0.5, i.e. the income tax exemption threshold in a country is only half its per capita GDP. For example, the average person in China earns 50,000 yuan but anyone earning more than 18,000 yuan will fall under the tax bracket. Similarly, the ratio of income tax exemption threshold to per capita GDP in Brazil is 0.8. It is 0.2 in the United States and 0.9 in Mexico. India’s ratio is 5 times greater than the world average. As the chart below shows, only Bangladesh has a greater ratio than India.

So, when the Economic Survey suggests that India has among the fewest taxpayers per 100 voters, it is equally important to consider this fact that India has one of the highest exemption thresholds for paying income tax.

Decoding India’s Low Tax Base Conundrum

In the Union Budget of 2017-18 presented by the Finance Minister recently, the income tax rate for the first income tax slab was lowered from 10 percent to 5 percent. So, India not only has a high income tax exemption threshold but also a very low rate for the first income tax slab.

Again, India stands out in this aspect compared to the rest of the countries in the world. The chart below plots the ratio of income tax exemption threshold to per capita GDP on the X axis and the rate of income tax for the first slab on the Y axis. As evident in the chart, India is a complete outlier yet again, even more of an outlier than Bangladesh, whose income tax rate for the first slab is higher.

Data source: Praveen Chakravarty

In the last two decades, the income tax exemption threshold has increased six-fold from Rs 40,000 to Rs 2.5 lakh. In contrast, the average annual nominal incomes of Indians have multiplied only three-fold in this period.

Clearly, with tax exemption thresholds rising faster than average income, the percentage of people eligible to pay income tax is bound to reduce or at best stay constant but not rise.

It is thus premature to conclude automatically that India’s inordinately low tax base is entirely a function of massive tax evasion by Indians. While lowering the income tax rates, had the Finance Minister also lowered the income tax exemption threshold to say Rs 1.5 lakh, 1.1 crore more Indians would have automatically qualified to pay income tax. This would have brought India more in-line with the rest of the world in terms of exemption threshold to per capita GDP ratio.

I wish to share some information with you, which will either make you laugh, or make you angry… there are only 24 lakh people in India who accept that their annual income is more than Rs 10 lakh. Can we digest this? Look at the big bungalows and big cars around you.

Narendra Modi, Prime Minister

This was Prime Minister Narendra Modi on New Year’s eve. Rs 10 lakh is 10 times the per capita GDP of India. 24 lakh Indians represent 0.36 percent of all Indians in the working age group of 20 to 70.

  • Even in much richer United States where income inequality is very high, just 0.9 percent of all working population report an income greater than 10 times their per capita GDP.
  • A similar ratio for the UK is 0.42 percent, i.e. only 175,000 out of an adult population of 41 million reported an annual income greater than 10 times the per capita GDP.
  • In more egalitarian Canada, only 0.39 percent of the adult population reported income of greater than 10 times per capita GDP.

Given India’s poverty levels, it does not seem entirely abnormal that only 24 lakh Indians reported an income greater than Rs 10 lakh.

In this backdrop of India’s pitifully low per capita GDP and inordinately high-income tax exemption threshold, the small number of taxpayers or high-income earners do not seem as anomalous as it is made out to be. Of course, one could argue that India’s GDP in itself is understated due to the large share of informal economy and workforce that escapes the tax net.

Regardless of one’s views on how much of India’s GDP is understated, it is indubitable that a big reason for India’s low income tax base is the high income tax exemption threshold vis-a-vis per capita GDP. Economists Thomas Piketty and Nancy Qian demonstrated this back in 2009 in a research paper that accurately predicted that India’s income tax base is likely to stagnate between 2-3 percent of the working population, driven by a high income tax exemption threshold.

Before we advocate or justify complex policy measures such as demonetisation or taxing agriculture income to widen India’s direct tax base, surely the fact that a large majority of Indians are anyways legally exempt from paying income tax due to the high exemption threshold should be a factor to consider?

Praveen Chakravarty is a Senior Fellow at IDFC Institute, a Mumbai-based think/do tank. His work focuses on financial sector legislation & political economy. Noise to Signal will bring you insights from that.

Leave a Reply

Your email address will not be published. Required fields are marked *