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Simpler tax = more tax for middle class
August, 14th 2009

If you think the new direct tax code unveiled by finance minister Pranab Mukherjee on Wednesday will save you tax, think again. For taxpayers in the lower brackets, taxes may actually go up, depending on various assumptions. People who make substantial income from buying and selling shares may also lose out.

As can be seen from the table (on p18), an individual with a salary income of Rs7.4 lakh per year and Rs50,000 worth of long-term capital gains (LTCG) on the sale of shares would currently be paying an income tax of Rs44,000. If the changes are implemented from April, 2011, tax paid will go up to Rs53,000. LTCG on shares refers to a situation wherein shares are sold a year or more after they are bought.

You will pay higher taxes for two reasons. One, for the sake of simplicity, the code seeks to do away with expense-oriented deductions like house rent allowance (HRA), leave travel allowance, medical allowance and even interest paid on repaying a home loan (on which currently a deduction of Rs 1.5 lakh is allowed. Two, the code proposes to do away with any differentiation between short and long term capital gains on the sale of shares. Currently, tax on LTCG is zero and on short term gains 15%.

Due to these reasons, the tableshows an increase in income tax paid by Rs9,000, or around 20%, to Rs53,000, as and when the new tax code comes into play.

We have assumed that the taxpayer is paying off a home loan and hence makes a deduction of Rs1.5 lakh for interest paid. But the taxpayer may not own a house and might be living in rented accommodation. If he claims the entire Rs2 lakh of his HRA as deduction, then the tax he would be paying currently will stand at Rs34,000. In the new scheme of things, he wouldn't be allowed to take a deduction against this expenditure.

And the tax he needs to pay will increase by Rs 19,000, or a humongous 56% rise to Rs 53,000.

The logic for doing away these deductions, as the discussion paper on the tax code clearly specifies, is that "For most taxpayers, particularly the small and marginal category, the tax law is what is reflected in the form. Therefore, the structure of the tax law has been designed so that it is capable of being logically reproduced in a form."

On the investing side of things, currently section 80C allows a maximum deduction of Rs 1 lakh for investments made in tax-saving instruments like provident funds, life insurance, new pension scheme, etc. Under the new direct tax code, this limit has been increased to Rs 3 lakh, as per sections 66 and 67 of the direct tax code. Under this limit, deductions can also be made towards the amount paid as tuition fees for the purpose of education of two children at any university, college, school or other educational institutions.

Even though this limit has been increased by Rs 2 lakh, it is highly unlikely that the middle class taxpayer will be able to utilise the entire limit, given his limited income.Other than this, the increased limit would have been of some help if deductions for the principal repaid on home loans were allowed, as is the case currently.

Tax saving instruments come with a lock-in and it wouldn't be advisable to lock in all the savings in such instruments. So, in the table, it has been assumed that the taxpayer continues to invest the same amount in tax-saving instruments as he had done before. But if he is in position to increase his investment in such instruments, he may end up in a situation wherein he might pay the same tax as he is paying now.

So, in any event, there is very little chance of more money falling into the pockets of the middle class taxpayer who earns between Rs 5 lakh and Rs 10 lakh.

Other than this, those who make a living out of selling stocks clearly need to be a worried lot, given that the distinction between various forms of income has been done away with. Right now, no tax needs to be paid on long term capital gains made on selling shares, but with the new code taxes will be paid at the marginal rate of the taxpayer.

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