Need for a more equitable and efficient Indian tax structure (direct & indirect taxes)

Economic theory says that for individuals a graded income tax rate based on income levels is a ‘progressive’ method of taxation and an indirect tax method on goods and services (not looking at the income level of the spender / purchaser) is a ‘regressive’ manner of taxation.  In India, we have income tax (direct tax method) and indirect tax in the form of GST / VAT / Cess, etc.

All over the World, attention is now being grabbed by the fact that the income tax of various countries (including India) is structured in a way that facilitates the top tier income earners to ‘manage’ their affairs so that income does not get recognized and no income tax becomes payable by them on income accrual basis.

One of the ways this is done is by pledging investments as security with banks / financial institutions and getting borrowings in your name for further reinvestment.  No income tax is payable, because the investment is not sold (value not realized) and hence no capital gains tax is payable.  The rich individual continues to expand his wealth through strategic and intelligent investing without the original investment ownership moving out of his / her hands. This problem is recognized by all finance / revenue department authorities across the World, but a solution has not yet evolved on addressing this matter.

Further in India, we have agriculture income being non-taxable upfront (regardless of the income amount involved), income tax payable on investments earnings (interest / dividend) – while the primary income source say salary income was already taxed. In my view, if the tree trunk has paid tax, the branches cannot be asked to pay tax.  The branches emerge from the trunk. 

For whatever reason, Income Tax law has become regressive instead of being progressive.  It favours the high income earners – gives tax exemptions on income recognition (agriculture and capital gains) and squashes the middle income earners. 

India’s political leadership and finance bureaucracy has to accept that individual Income Tax law has been a huge failure for tax resource collection.  Only formalized employment individuals and pensioners / retirees largely pay proper income tax dues.  The non-formalized economy contributions are meagre to Income Tax collection and there is no mechanism available / worked on to get this section of the economy contributing to income tax.  Excluding agriculture income fully is another great injustice.

We are also aware that filing of Income Tax Returns (ITRs) and possession of PAN Cards are not in sync with one another.  All PAN Card holders are not filing ITRs and there is no executive effort to address this injustice.  Out of 70+ Crore individual PAN Card holders, around 7.2 Cr ITRs were filed as per latest records for accounting year 2025-26. The Finance Ministry is pleased with Tax Deduction at Source provisions (TDS) and recovery of income tax on the formalized economy individuals.  No effort is made to cast the net wider on the non-formalized economy individuals.

If Finance Ministry at the Centre is unwilling to address the regressive nature of our Income Tax Law, then it needs to seriously understand that this is a matter of political unhappiness.  At some time, the anger will boil over.  Before we reach that stage, we could have a review of not looking at individual incomes for taxing but looking at Expenditures.

Any tax method must have 3 requisites:

1. The method should be easy to administer.  There cannot be a method that is so costly that the benefits of tax collection are sharply reduced / diminished;
2. The method must have built in equity.  There cannot be favoritism in tax charge and collection.  Income tax in India totally fails on this count of equity;
3. The tax method should be simple and easy on the tax payer.  It must have the ability to scale up and ensure that all eligible tax payers are caught in the tax net. Tax evasion cannot be looked away.  Indian income tax places a premium on tax evasion and there are many willing to take the Risk between Tax Evasion and getting caught.

Since income tax has not found it’s footing in terms of numbers of proper and correct value tax payers and there is clear indication of people evading or paying less income tax – there is a need to look at the tax structure of India again.  Tax payers filing Income Tax Returns (ITRs), currently feel a great sense of injustice and deprivation.  If a form of indirect tax brings more equity and tax collection, so be it!

As a country we need to look at the Expenditure / spendings side for tax collection and forget the Income side.  There are advantages of giving up on the failed idea of income tax.  They are:

1. When income is not taxed, there is no concept of income tax evasion.  Concept of ‘black money’ dies and the economy does not any more add to the ‘black’ section.
2. Individuals get full gross credit of their income (except statutary deductions for retirement corpus, etc).  They are then free to spend the money – leading to increased investment and consumption.  The idea of directed investments for income tax relief comes to an end.  Your risk appetite determines your investment / savings corpus.
3. The entire support structure for income tax administration and verification is freed to focus on the indirect tax side of tax.

India needs to accept that the entire concept of individual income tax has failed in India – due to the structural issues of the economy and due to political compromises which bring in inequity for individual income tax payers.  The budget estimates for Year 2026-27 shows that individual gross income tax collection is projected at Rs 1466000 lakh crores (incl devolution to stares).  An argument that may come up is whether the loss of Income Tax of this amount can be made up by an alternative indirect Tax.  

There are two ways of approaching this argument in favour of ‘Expenditure’ / Alternative Tax regime.  They are:

1. Recognize that individual income tax law has failed in tax collection.  The % of individual income tax collection to GDP is around 4.2% in India, while the average realization should actually be 10.0 to 11.0 %.  This is a red flag of failure of income tax method and like Estate Duty and Wealth Tax for individuals were removed, so must Income Tax.
2. The Finance Bureaucracy and political leadership must find ways to fill up the gap.  The Budget Estimate of individual Income Tax collection for Year 2026/27 is Rs 1466000 Crores.  Let us assume that 80 Crs numbers of individual PAN Cards are in circulation.  The Income Tax received from each PAN Card holder is Rs 18325/- per annum.  This is a very small amount to be recovered by an alternate mechanism.

There is huge potential for Tax accretion in the Central Govt Budget exercise.  The tax recovery based on % GDP has potential to double itself.  This will be very helpful for additional funding of states devolution, Defence, Home, Health etc.  India needs to look at it’s tax collection structure anew with fresh thinking.  Income Tax is not a special species, which cannot be touched. 

There will be a professional economists and tax consultants / finance professionals view that any tax on the Expense side will show an artificial  higher inflation rate and ‘increased’ GDP numbers.  That is true.  To protect the lower income persons, the items of consumption that they deal in must not have any new incremental tax.

Higher tax collection potential will make this worthwhile.  The new Tax method needs to be thought out and implemented.  If India could introduce GST from July 2017, then a replacement to Income Tax can also be visualized.  

In India, income method of Tax has failed due to tax evasion, income exemptions and limited state resources for follow-up on tax recovery.  A new method is necessary which will not cause pain to the tax payer and easier collection to the tax authorities.  Annual income tax amendments for individuals can also be done with.  A more consistent method will come in.

An alternative mechanism of tax which touches all eligible tax payers on some determined matrix and which takes care of income differentials (you cannot spend what you have not earned or can afford) will automatically take care of the equity element, since all tax payers are uniformly impacted.