In a surgical strike, perfectly timed to coincide with the Delhi elections, Finance Minister Nirmala Sitharaman cut income-tax rates across the board from 1st April 2025. A total income of Rs 12 lakhs will henceforth not attract any income tax . This figure earlier stood at Rs 7 lakhs. Simultaneously, the FM also reduced other rates of income tax in such a way that taxpayers with a total income of Rs 12 lakhs would save Rs 80,000; this relief gradually increases to Rs 1.10 lakhs when such income rises to Rs 24 lakhs or higher. Thus while all taxpayers have benefited from this reform, more than a third of the existing 8 crore taxpayers have been absolved of all liability to pay any income tax.
Now that the euphoria created by this measure amongst the middle classes has now quietened, we can analyse its impact much more holistically – on tax revenues, work ethic, taxpayer behaviour and morality.
Contrary to popular belief, a decrease in tax rates does not ipso facto lead to lower revenue for the government; likewise, an increase in such rates does not necessarily lead to higher revenue for it. Quite simply, the intuition behind Arthur Laffer’s theory is that when the rate is zero there will be no revenue; when it is hundred percent, there will again be no revenue because people will stop working. Starting with a high tax rate, above the optimum level, a rate cut will initially yield increasing revenue; below this optimum point, it will yield declining revenue. So whether revenue will increase with a tax cut,will depend on whether or not the new rate is above or below the optimum.
In real life there is no empirical evidence to support this principle in the west. India, however, is the only country where it appears to work: tax revenues have increased every time rates have dropped. This happened, for example, when Indira Gandhi reduced the maximum marginal rate for individuals from 97.75% to 77% in 1975-6, and 66% in 1977-78. Tax revenues shot up from Rs 362 crores in 1974-75 to Rs 480 in 1975-76 and Rs 542 crores in 1976-77. Successive governments since then have reaped similar bonanzas. On all these occasion revenues increased, on some times, quite dramatically. What explains this phenomenon? Typically, a tax cut, in a high tax regime, drives people to work harder because they now get to keep a larger share of the additional income they earn. Some people, may be driven towards preferring more leisure time, because they may find that they can get the income they desire by working less. In a country like India, however, most people much prefer higher income to leisure. Consequently they offer such income for taxation; the economy grows faster because people work harder and government revenues increase.
A reduction in rates of income-tax may also improve compliance because many people do not now find it worthwhile to take the risk to evade or avoid paying tax and getting caught. This again results in higher revenue.
So far so good. The question is: how do you know that the optimum point has been reached- from where, every cut in rates will only generate lower revenue. This is quite often a matter of judgement. FM Sitharaman might very well have made the right call, considering the quantum of evasion and tax avoidance in the country. Secondly, such cuts also accord with our widely accepted civilisational principles; according to Chanakya’s Arthshastra and the Ramayana, two of our ancient classics, the rate of tax should not ordinarily exceed 16% to 16- 1/2%.
But whether or not you will support this measure will ultimately depend on your political beliefs: To give a further impetus to the economy, should the government retain this revenue of Rs 1 lakh crores and spend it on infrastructure projects; or should it pass it on to the middle classes to boost consumption and investment? Those who prefer the first alternative would also argue that the taxpayer base in our country is already very small- about 8 crore out of a population of 145 crore people. Lopping a third of this base is iniquitous in a moral sensesimpliciter. On purely pragmatic considerations, however,since the measure is likely to improve compliance, incentivise hard work, spur growth, generate more revenue, and reduce evasion and litigation, it may very much be in the larger national interest!
The Author was Chief Commissioner of Income-tax and is the author of the Moral Compass- Finding Balance and Purpose in an Imperfect World
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