According to a Mint exclusive report, the finance ministry is working to declutter the tax system. This is welcome. The ministry, according to the report, is likely to sweeten the no-deductions-lower-rates option by lowering the tax rates further. How can it be made to work successfully this time?
What is needed is a simple and efficient tax system in which compliance is easy for taxpayers and evasion tough. Plus, the tax treatment of savings must change so as to encourage people to save smartly—given the absence of adequate and proper social security system in the country and a large portion of the population being of working age.
Let’s first understand the new regime introduced in FY 2021. In this option, income between Rs. 5 lakh and Rs. 7.5 lakh is taxed at 10%, while income between Rs. 7.5 lakh to ₹10 lakh attracts 15% tax. Whereas in the old regime, the entire income up to Rs. 10 lakh is taxed at 20% flat.
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The earlier ₹10 lakh-plus slab that attracts 30% tax is broken into three parts–with rates of 20% for Rs. 10-12.5 lakh, 25% for Rs. 12.5 lakh-15 lakh and then 30% for Rs. 15 lakh and above.
While rolling out the new option, the government showcased with illustrative examples how for the same income, tax outgo in the new regime is lower. Yet, only few taxpayers have opted to give up tax exemptions and deductions. Most have preferred to stay with the old scheme.
The reason being that giving up tax breaks—such as on savings parked with the public provident fund or the premium paid on life insurance—require fundamental rejig in long-term financial and retirement planning.
These considerations are likely to continue to dominate taxpayers’ choices. So, there is no guarantee that sweetening of the exemption-free tax regime by further lowering of the tax rates will have many more takers.
The income tax system must be reformed in more fundamental ways. One, the government must scrap the dual tax system, and have one regime only. Two, tax slabs must be compressed to two or three. This will bring down what is called the ‘bracket creep’ where inflation drives an individual to pay tax at a higher rate, even if her income has not risen in real terms. A liberal tax rate structure should go hand in hand with removing deductions. Three, reform in the tax treatment on savings should not be delayed.
The government could look at doing away with the tax breaks for savings schemes such as for investments in the PPF and post office savings, and instead raise the threshold limit for paying income tax. Savers should not be influenced in their financial planning decisions by tax breaks on offer. At the same time, the tax system should not treat returns or earnings from investments differently from earnings from other sources of income.
What in tax jargon is called the exempt-exempt tax treatment method should be rolled out. In this, no saving is taxed, but only income from an asset would be taxed. Meaning the gains from, say a home sale, are not taxed if invested in shares and vice versa.
Broadly, this principle is followed now in the sale of housing properties. If proceeds from the sale of a house are invested in a new house, then the capital gain on the sale is spared from tax. Extending this to all financial assets to encourage churning merits consideration. This will allow people to defer their tax liability to the point when the amounts are withdrawn, and leave more financial savings.
A fallout would be that India would end up taxing retirement savings. For a country that does not have a proper social security system, that calls for relief or compensation. Lower tax rates and wider slabs, as proposed in the sweetener, however, will take care of that.
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