Flat Tax, Part 2

In a previous column, I’d suggested a flat 10 per cent personal income-tax rate on all taxpayers with a taxable income up to Rs 20 lakh and a flat 20 per cent tax rate on those with a taxable income above Rs 20 lakh. Those with taxable income below Rs 2.50 lakh would, as now, remain exempt.

Let’s break this down to see how practical the proposal is and what the impact would be on tax revenue.

Only 3 per cent of Indians pay personal income tax. In the United States, for example, 40 per cent do – 14 crore people out of America’s population of 32 crore.

Of India’s 3.50 crore taxpayers, 3.40 crore people have taxable income below Rs 20 lakh. The number of taxpayers with taxable income above Rs 20 lakh is just 0.09 crore people.

The 3.40 crore taxpayers in the slab below Rs 20 lakh together pay a mere Rs 1 lakh crore in taxes every year – at less than Rs 30,000 on average per assessee per year. That’s an effective tax rate below 5 per cent of taxable income, largely due to exemptions and other tax avoidance schemes.

A flat tax of 10 per cent on taxable personal income below the Rs 20 lakh slab would therefore garner more revenue than is generated today from this category of taxpayers (who comprise over 98 per cent of all personal income taxpayers but account for only 35 per cent of total personal income-tax collections).

Complex tax rates drive tax revenue down. A simple, flat rate will drive it up, eliminating grey areas of avoidance and exemptions.

Three conclusions present themselves. First, it makes little sense for the income-tax department to spend administrative time and resources on small taxpayers.

Second, the key is to simplify the entire tax system, not piecemeal as finance ministers tend to do. Simplification is a sure way to improve compliance.

Third, greater compliance will automatically widen the tax base over the next few years from 3.50 crore taxpayers to around 5 crore taxpayers – provided the tax system is fair, transparent and simple. The more complex it is, the greater the incentive for small businessmen, traders, jewellers and professionals (who get paid in cash) to stay out of the tax net.

As Finance Minister Arun Jaitley rises to deliver his third Budget on February 29, the critical figure will not be the fiscal deficit for 2015-16 (which will, by various accounting fudges, be kept to 3.9 per cent of GDP) but the revenue deficit.

The problem is that of approximately Rs 14.49 lakh budgeted tax revenue in 2015-16, the excess of expenditure over revenue is largely attributable to interest payments. These devour over 20 per cent of revenue – more, for example, than the entire defence budget.

This cost of borrowed funds is an old legacy of financial profligacy. The only way out of the debt trap is to increase tax revenue significantly. And the only sustainable way to do that is by widening the tax base. Simplify tax slabs, flatten the tax rate and broaden the base: the rewards will follow.

This is Jaitley’s third Union Budget. If he doesn’t make bold, decisive tax reforms, it could be his last.