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Is inflation-adjusted tax system feasible?
August, 09th 2008

With inflation rate running in double digits since the last two months, and with not signs of it falling in the near term, an issue that needs to be looked at consideration is whether the Income-Tax Act should be indexed for inflation?

How inflation impacts taxes?

Inflation greatly distorts the tax system not only relating to direct taxes such as income-tax, wealth tax, gift tax, estate duty, etc., but other taxes as well.

First, there is distortion in the traditional measures of the tax base, that is, the income or wealth concepts to which the tax rates are applied.

Second, inflation constantly changes the real effect of the tax rate structure. The basic exemptions, the standard deductions, the composition of tax brackets and many other features of the tax structure are specified in monetary terms.

If the law does not counteract the inflationary effects, the basis and the limits fixed get continuously eroded in terms of real purchasing power.

As a result, as the income rises, the higher income gets pushed into higher tax-brackets even though the rise in income does not keep pace with inflation.

The Mathews Commission set up by the Australian Government years back, to study the relationship between inflation and taxation , observed thus: Whether the rate of inflation passes a critical level, its effect on the taxation system change in kind as well as degree and it becomes difficult for the economic system to adapt in conventional ways.

Indexation as counter measure

Indexation is seen as a remedy to counter inflation on taxes. Tax economists have suggested two types of indexation for this purpose structural and measurement.

Structural indexation is required because the taxes are progressive and indexation would convert money components of the rules by which tax liabilities are computed into constant rupee amounts. This can be done by raising them each year by the rate of general price inflation (like wholesale/consumer price indices) in the most recent 12 months period for which data is available.

Measurement indexation is used to shift the tax base from nominal money income to price adjusted or real income base. The measurement of taxable real income during a given period of time has to be based on a general price index that covers all consumption goods and services.

Equity, it is said, demands that persons should pay tax on their real incomes, not enhanced incomes, which do not add to their money power status consequent to inflation.

Requisites for indexation

Reliable indices are necessary for efficient working of an inflation-adjusted tax system. In India, the two major indices are the wholesale price index (WPI) and the consumer price index (CPI). But there are wide differences in these. This is because of the fact that there are differences in their weights. In the WPI, consumer goods are allotted a lower weightage. The composition of the CPI is often a subject of controversy. It has been accepted that the two indices are not comparable. The problem then arises as to how one should proceed.

Further, different price indices are relevant for different sections of the income-tax payers. The tax department may have to think of the price index which is relevant to taxpayers earned income exceeding the exemption limit per year because an index which is relevant to earnings less than such limits cannot be very useful for tax indexation as such persons fall outside the scope of tax. Also, CPI may have no relevance when one considers the cases of limited companies and firms.

There is another aspect as far as Central Government employees are concerned. The Pay Commission has a prescribed formulae for neutralising the effect of rising prices (cost of living), by automatically increasing emoluments through dearness allowance.

Some State Governments and public sector undertakings (PSUs) have also adopted the Pay Commissions formula. The issue that then arises is whether such persons too need the benefit of inflation adjusted tax rates.

Automatic indexation

The concept of price indices becomes relevant when the proposal is to have automatic indexation in the tax law as an inbuilt provision. There is considerable debate on the question whether automatic indexation should be adopted in tax laws. There are arguments that are advanced in favour and against such indexation:

Points in favour: Under the system of indexation, the government undertakes to protect the taxpayers from the hidden effects of inflation on their income-tax liability, independently of what discretionary measure may be taken for other reasons.

The delay between the increase in nominal tax liability and the resultant adjustment is predetermined and, therefore, ensures against any delay in relief.

Indexation is considered as establishing point of reference against which other changes to the income-tax system can be evaluated and, thereby, transparency of tax policy improved.


It acts as a brake on the growth of public expenditure and is considered to be a stimulant for the government to curb inflation because it removes the revenue increasing effects of inflation in the income-tax system

It provides for making adjustments within the framework of legal provisions and not on the whims and fancies of the Finance Ministers.

Automatic indexation helps avoid larger adjustments to be made at less frequent intervals.

Indexation has been viewed favourably from the point of view of employer-employee relationship. It, among other things, softens the trade unions attitude towards wage negotiations.

Arguments against: It provides less discretion to the government for adjusting taxation policy to economic circumstances.

It could weaken the desire of the government to check inflation and could limit acts for efficient adoption of taxation policies for economic needs.

Indexation can be considered as an indication of a helpless attitude on the part of the government in the matter of checking of the inflationary trend.

Indexation destroys flexibility in a tax system. The governments desire to gain extra revenue in times of need may get frustrated because of policy of indexation.

It makes the tax laws complicated.

Such arrangement damages the built-in stability of the tax system.

It requires data processing on a very wide scale.

At the technical level, in the matter of implementation, a number of problems are likely to arise.

Discretionary adjustments

In the Indian context, the best way to give relief for inflation in the income-tax and wealth-tax laws is through discretionary adjustments, as is being done at present through raising exemption limits, adjustment of tax brackets, changes in standard deductions, adjustment in depreciation rates, provision of additional depreciation, in addition to normal depreciation, investment allowances, development rebate, giving weighted deductions, etc.

Since the tax rates are reviewed during the annual Finance Act exercise, the position in this regard can be reviewed yearly. What needs to be ensured is that such adjustments should be objectively conceived, faithfully implemented and there should be no elements of subjectivity, personal bias and arbitration in such decisions.


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