Can income tax be abolished? What are the pros and cons of abolishing income tax?
March, 13th 2012
Mina and her colleagues don't look forward to the months of February and March. The take-home salary during these two months is the lowest. After employees have provided proof of tax eligible investments and expenditure, post a quick computation by the in-house payroll departments, the remaining tax liability is deducted against the salary income of the two remaining months of the fiscal year.
"Why must I pay a high tax rate of almost 31% and get nothing in return," Mina has exclaimed in anguish on more than one occasion. She wishes for complete abolition of income tax. No doubt, this has been the secret if not vocal wish of many salaried tax-payers. Those earning a taxable income of more than Rs 8 lakh fall in the highest tax bracket of 30% plus an education cess of 3%. But is Mina justified in her complaint?
A quick glance at worldwide personal tax rates shows that the maximum marginal rate of tax in Denmark, Sweden, Belgium and the US is perhaps the highest in the world. Yet a host of benefits are also provided to its citizens such as unemployment benefit, retirement benefit, pension, healthcare ...The grass does appear greener on the other side, but there is also a cost attached in the form of social security taxes.
For instance, a salaried employee having a gross income of $100,000 would be subject to social security tax (5.7% and 7.7% being the employee and employer contributions ). It can be argued that we in India also contribute to PF. One can also say that in these countries it is the richest of the rich that are subject to the maximum marginal rate of tax . The debate can rage on and on ...
Sometime last year, while flat tax was the topic of discussion in several parts of the world, including the US, a study of 54 different countries by Shigehiro Oishi, a psychologist attached to the University of Virginia, found a direct co-relation between progressive tax policies and overall happiness. The report emphasized that what matters is what governments do with the tax moolah they collect. Thus citizens of Denmark, which has a high maximum marginal rate of over 50%, were still happy.
Of course, there are countries where individuals do not pay any tax, these are typically tax havens such as the Cayman Islands, where the zero tax rate is meant to attract the rich and the famous, or resource-rich countries such as those in the Gulf region.
Neil nods his head absently, while his wife continues to rant. In reality, he, as the owner of a medium-sized business is tired of litigation, of ever changing laws and a high MAT of around 20% (with the corporate tax rate being close to 33%).
A quick glance at worldwide corporate tax rates shows that several countries have corporate tax rates falling in the 25%-35 % bracket, US and Pakistan have a rate of 35 %, Australia (30 %), UK (26 %), and China (25%), barring a few sectors which get favourable tax treatment ). Once again, tax havens such as Cayman Islands have nil rate of corporate tax, Cyprus levies 10%, and Mauritius levies 15% for non-offshore companies. Some developed countries like Germany (15%) and Singapore (17%) do have more favourable rates of tax. The cost of collecting income tax is higher (more than 0.65% of the revenue collected), whereas even as no statistics are available owing to the indirect tax levy being collected both at central and state level, the cost of indirect taxes collection is assumed to be much lower.
Of course, for each of these points there can be counter arguments. A complete abolition of direct taxes is not required to tackle the problems of black money or to change consumer habits. Cost of collections can be lowered through use of technology ; anti-corruption measures can ensure better utilization of tax money and also curb black money. While tax-free agricultural income is a sore point for urban India, with fragmented farming and low yields, majority of rural India would continue to be outside the tax bracket.
Why must income-tax be abolished:
Mina has many arguments up her sleeve in favour of income tax abolition.
>No income tax means more spending power, more demand, more manufacture, more jobs. In short, a faster growing economy Income tax leads to tax evasion as people don't declare their true income. Estimated figures of black money stashed overseas run into a mind boggling figure of $500 billion. If there is no income tax there will be no need to evade tax!
>Abolition of I-T will mean that everyone will pay taxes. Why should agricultural income continue to be exempted?
>No income tax will mean a greater incentive to work, after all, a large chunk of our salary or business profits goes towards payment of taxes plus the utilization of our taxes is shrouded largely in mystery
>Certain habits can be curbed through elective use of the indirect tax weapon, such as very high taxes on fuel guzzling imported cars. Don't we all crave a greener world?
>The cost of collecting income tax is higher (more than 0.65% of the revenue collected), whereas even as no statistics are available owing to the indirect tax levy being collected both at central and state level, the cost of indirect taxes collection is assumed to be much lower
Of course, for each of these points there can be counter arguments. A complete abolition of direct taxes is not required to tackle the problems of black money or to change consumer habits. Cost of collections can be lowered through use of technology; anti-corruption measures can ensure better utilization of tax money and also curb black money. While tax-free agricultural income is a sore point for urban India, with fragmented farming and low yields, majority of rural India would continue to be outside the tax bracket.
Income tax is progressive, indirect tax regressive:
The general understanding is that income tax is progressive in nature. The rich pay more and in turn this money is used to benefit the society, including the weaker sections of society . The'Occupy Wall-S treet Movement' threw up an interesting statistic. In the US, the top 1% of society contributes 40% of direct tax collections. Back home, if Mumbai tax collection figures are taken into consideration , the story is similar . Mumbai contributes anywhere between 30 % and 40% of India's direct tax revenue.
In India , the overall tax /GDP ratio was 10.18 % for FY 2005-06. Of this, direct taxes contributed 4.61 % and indirect taxes contributed 5.57%. The share of direct and indirect taxes in 2010-11 was 6.24% and 4.56 % respectively. Thus, it is direct taxes which contribute a growing share and of such share , the rich are the major contributors , making it a truly progressive regime.
On the other hand, in the western world, especially in the EU, countries (and not just Greece) are increasingly turning towards indirect taxes in a bid to reduce budget deficits and improve collections . If one looks at some global examples, countries that have more recently introduced a broadbased VAT/GST have used the personal income tax schedule to compensate for the impacts of a broad-based indirect tax regime.
In late 2010, when New Zealand raised its rate of GST from 12.5% to 15%, it also changed income tax rates (from a high rate of 39% in 2008 to 33% now ) and provided for various allowances to compensate lower income tax payers and reduce the regressive impact of indirect taxation. In India, the total shortfall in collections as of now for direct taxes (corporate tax and personal tax ) is Rs 1.72 lakh crore (as on February 20) - budget estimate being Rs 5.32 lakh crore for 2011-12 . For indirect taxes , the shortfall in collection is Rs 0.75 lakh crore (till January 2012) - the budget estimate being Rs 3.92 lakh crore.
If we assume that Mina's wish came true and income tax (for both individuals and corporates ) was abolished in toto to ensure that there is no deficit in total budgeted targets , the indirect tax machinery will need to work overtime and the tax rates would need to be higher.
The biggest criticism in relation to an indirect tax regime is that it is regressive in nature. You buy, you pay! As things stand at present, the excise slabs in India to an extent can be called progressive in nature, with nil or low tax (up to 5%) on essential items like flour, bread, butter, milk and LPG (for households). On the other hand , sin products like tobacco and imported wines suffer heavy indirect tax levies . On abolition of income tax , hiking rates on essentials to meet the collections would badly hit the aam-aadmi.
Yet the above measures are not easy to introduce or to implement. Further, even if implemented, it would be impossible for the new mechanism to fill in the entire gap which total abolition of direct taxes would result in. For example, to what extent can tax rates be hiked on luxury items or niche luxury items?
However, steep rates on niche luxury items would further shrink the population which consumes these products, resulting in the tax collection estimate from this mechanism not being met. To bridge the ever widening tax collection gap, there would be a trickle down effect, with the tax rates on even essentials rising.
The Organisation for Economic Cooperation and Development (OECD), has analyzed the macro-economic effects of a shift towards indirect taxes from direct taxes for 15 EU countries. It concurs that a problematic consequence of a tax shift is that it would result in a one-off increase in price levels. In countries with extensive price and wage indexation (where the wage is linked to inflation ), it would result in a wage price spiral or else it could lead to negative effects on consumer and investor confidence.
In India, if there is an immediate and complete abolition of income tax , we are likely to see rising prices and a huge dent in consumer and investor confidence . It is true that the ills of black money would be abolished if income tax were abolished, but one cannot throw the baby out with the bath-water.
In recent years we have seen a crackdown by the OECD and the G20 on noncompliant countries (such as tax havens ). If India were to abolish direct taxes, it too could face similar repercussions from the international community. For both Mina and Neil and many others , at least for now , abolition of income tax will remain an utopian dream.