Data suggest that a tax rate increase for a few rich people puts little back into the economy compared to an across-the-board increase

I think there should be stability in tax rates but we should consider the argument that very rich should be asked to pay a little more on some occasions,” said Finance Minister P Chidambaram weeks before the announcement of the Budget 2013 proposals. Setting expectations, it was followed by a 10 per cent increase in the surcharge on tax for individuals with income above Rs 1 crore, though, the slab rate remained unchanged. India’s rich reciprocated the FM’s passionate appeal and responded positively.

The debate on levying a higher tax resurfaced last week when the Direct Taxes Code (DTC) was expected to be tabled before the Cabinet as a prelude to its passage in the present session of Parliament. Media reports seem to suggest that DTC was withdrawn from the agenda because it met with stiff resistance from the Prime Minister’s Office, particularly in relation to the levy of higher rate of tax and the imposition of special tax on dividends above certain limits.

The basics and history of India’s tax policy suggests that increase in the number of taxpayers has occurred and so has compliance with a reduction of tax slabs and moderate rates of tax. From less than 10 million taxpayers to over 35 million in less than a decade and compounded annual growth in personal tax collections of almost 15 per cent in the same period – the foundation for which was laid by P Chidambaram himself in his dream Budget of 1997. Should the tax rate hike become a reality, roughly 42,000 individual taxpayers will be impacted on the assumption that its target for income above Rs 1 crore (as opposed to Rs 10 crore reported in the media). I wonder what incremental tax revenues the government expects to garner, but it has to weigh the consequences carefully.

If one goes by the math estimates in the 2013 Budget that it would collect Rs 13,000 crore by way of an increase in surcharge and if one extrapolates the incremental tax due to the rate change, it is unlikely to exceed the same amount in a given fiscal year. However, an increase in the slab as part of the DTC would mean a permanent increase as opposed to a temporary surcharge, which the FM promised to take away as soon as the fiscal deficit target is manageable. In the event that there is an increase in slab rates, the sums could potentially grow over the years in anticipation of the fact that more individuals could be added to the elite list of those with incomes above Rs 1 crore.

The economic growth and deficit arguments are powerful. But economics has its limitations. It can tell you how to manage the deficit; it cannot tell you how to distribute wealth as an argument for a higher levy. More importantly, it will seldom guide you to manage investor sentiments and confidence. Having said that, rare conservatives believe that higher taxes need to be part of the deficit debate as is the case in many economies, particularly in the US, which debated the “Buffet Rule” advocating top earners pay higher taxes. It is perfectly fine for our policymakers to have this debate in the context of India.

India has maintained a balance between a progressive (slab system) and moderate tax regime in the past 15 years. On one hand, it is legitimate to simply believe that the rich should pay a relatively higher tax rate, but opponents argue that by asking the top 1.5 per cent to pay more for fairness’ sake is an idea detached from reality.

The Organisation for Economic Co-operation and Development (OECD) reports that the US collects 45 per cent of household taxes (which includes state and local levies) from the top 10 per cent taxpayers. This puts the US first among 24 OECD countries as the highest taxed country (at the elite level) compared to an average of 31.6 per cent for the others in the group and, mind you, this is the total household levy that may include property taxes as well.

It’s not just the tax rate; what your top 10 per cent taxpayers contribute to the share of total income and tax collections becomes an important benchmark for any economy. If the government expects to collect (this fiscal) Rs 13,000 crore by way of an increase in surcharge levy from its top 1.5 per cent taxpayers, you are looking at a total tax collection of Rs 143,000 crore, assuming that the incremental surcharge represents 3 per cent of total tax. This is a whopping Rs 3.4 crore per individual and roughly translates into a material portion of estimated personal tax collection. The math may not add up precisely but it’s an important statistic to ponder on.

Non-partisan economic analyses show that a tax increase could run the risk of lowering demand and in the long term impact economic growth particularly in a growth-oriented country such as India that will continue to add more and richer taxpayers. Contemporary data for emerging economies suggests that a tax rate increase for a few rich people puts relatively little back into the economy compared to an across-the-board increase, though advocates of moderate tax rates at high income level believe that the top 2 per cent of earners account for a disproportionately large proportion of total consumer spending. Most conservatives believe that the actual number of taxpayers in the elite group should be three, if not, four times 42,000 owing to the interplay of the parallel economy.

With tax administrative reforms, compliance will improve bringing the “disguised elite” into the tax net and I estimate that this figure would jump rapidly – it could be anyone’s guess what it would look like in the next five years, but it surely will contribute materially to total personal tax collection. The question to debate is: shouldn’t we be taking a long-term view? For once, I am glad that the DTC is delayed!