Income tax returns- From fiction to fact

This article was first published in Business Today on January 20, 2017; http://www.businesstoday.in/union-budget-2017-18/expectations/income-tax-returns-from-fiction-to-fact/story/244640.html

“Income tax returns are the most imaginative fiction being written today.”–Herman Wouk, a Pulitzer Prize winning American author, who is more than 100 years old now!

We know that this quotation is quite apt for India. Prime Minister Narendra Modi said in his address to the nation on December 31^st 2016 that only about 24 lakh people declare income more than Rs10 lakhs in India. “Can we digest this? Look at the big bungalows and big cars around you. If we look at any big city, it would have lakhs of people with annual income of more than 10 lakh”, he said.

He was of course right in expressing his anger towards people who either don’t declare any taxable income or under declare taxable income, with the aim to evade tax. All the honest tax paying citizens of the country feel the same anger.

In the recent weeks, there have been a lot of indications from ‘sources in the know of things’ that there may be some incentive for more people to pay taxes. These could be in the form of lower tax rates, broadened tax slabs, bringing in standard deduction and increased exemption limits. As per many media reports that quote ‘officials involved in the budget making process’, the focus would be on widening the tax net.

Direct taxes are the sole jurisdiction of the Central government. Yet, no government has taken any radical steps to simplify the income tax act or to crack down on non-compliance in a major way. In the 1970’s the income tax rates in India were draconian with the highest tax slab resulting in more than 90% effective tax rate. In the decades of 1980s and 1990s the direct taxes started to get rationalized. In the FY 1997-98, the highest tax slab was brought down to 30%. Direct Tax to GDP Ratio was 3.25% in Financial Year (FY) 2000-01. It improved to 5.55% in FY 2014-15. Was it due to the ‘Laffer curve’ effect?

‘Laffer curve’ theorizes that at 0% tax rate, there will be no tax collection and at 100% tax rate, nobody will pay tax; meaning no tax collection. The theory implies that there is an optimal tax rate at which the tax revenue will be maximized. There is an arithmetic effect of a change in tax rate and a counter economic effect. For example, if the tax rate is decreased, the arithmetic would imply that the tax revenues will decrease. But the economics will imply that more people will pay taxes at lower rates and hence the revenue may be higher. Similarly, if the tax rate is increased, the tax revenue will increase based on simple arithmetic, but the economics would imply that more people may look for ways to evade and avoid tax thereby reducing the revenue. There is an equilibrium rate at which the tax collections get maximized.

So did the lowering of tax rate in late 1990s result in higher tax collection over the years (these things generally take a long time; 5-10 years or more to show results)? Or did the Direct Tax to GDP Ratio improve due to high economic growth during the last decade?  If we see this in the perspective of India’s GDP per capita, we find that while Direct Tax to GDP Ratio became 1.7 times from FY2001 to FY2015, the GDP per capita increased 5 times during the same period. It may be reasonable to conclude that the increase in direct tax collection was due to improving economy, albeit at a much slower pace than the economy!

So would a reduction in tax rates, as is widely expected from the forthcoming budget, result in widening the tax net and increase in tax revenues? If there is scope for people to escape the scrutiny of the tax men by either bribing them or by remaining below their radar, the answer would be No! Both may happen in India as corruption is rampant and the scrutiny is limited! The tax administration or the tax men are simply not geared up to take up the task of scrutinizing people at a mammoth scale that is warranted in the case of India where only about 4% of the population file tax returns.

So how will lowering the tax rates help the government? Well, it will be a goodwill gesture with a prayer in their heart that the lower tax rates result in inducing more people to start filing tax returns. The inconveniences suffered by the public through the process of demonetization might appear to be worthwhile (especially for those who pay taxes honestly) if they see some savings in terms of taxes. It will appease the honest taxpayers to some extent.

This move will work in improving the fiscal situation of the government if effective use of technology is made to crack down on people who have been totally outside the tax net so far, as also those who have been under-declaring income. A lot of this data will now be available with the Income Tax department thanks to ‘demonetization’ and reporting of deposits by banks to the tax authorities. The momentum should not be lost and without harassing the citizens, explanations must be sought regarding sources of income and mismatch of declared income versus deposits in banks. For most ordinary citizens, a query from the income tax department would be enough to put their house in order.

This is an opportunity for the government to de-fictionalize the income tax returns of people and get them to face reality!