How to Avoid Bracket Creep

The Economic Times - - Breaking Ideas - Indira Iyer

The re­cent an­nounce­ment of the year-on-year growth in net di­rect taxes at15.7% in the cur­rent fis­cal year cor­rob­o­rates the buoy­ant trend in di­rect tax col­lec­tions over the past few years, both due to an in­crease in the tax base as well as im­proved tax com­pli­ance. With such en­cour­ag­ing trends, it’s an op­por­tune time to think of fur­ther in­no­va­tions to make the tax sys­tem more re­spon­sive to eco­nomic fun­da­men­tals and en­hance com­pli­ance. One way to do this is by in­fla­tion-in­dex­ing the tax brack­ets.

This can po­ten­tially make for a more pro­gres­sive tax sys­tem by min­imis­ing ‘bracket creep’ — the sit­u­a­tion where a tax­payer’s in­come in­creases over time, but the tax rate thresh­olds re­main the same, thereby pos­si­bly mak­ing him or her pay taxes at a higher rate due to en­try into a higher bracket, even though in real terms, his or her in­come may not have in­creased. This may make the tax sys­tem more re­gres­sive, par­tic­u­larly for those close to the up­per thresh­olds in each tax bracket.

Con­sider an in­di­vid­ual declar­ing a tax­able in­come of .₹ 4.80 lakh. Cur­rently, she falls in the .₹ 2.5-5 lakh tax bracket and pays taxes at a 5% tax rate. Now as­sume that this in­di­vid­ual’s nom­i­nal wages in­crease at 8% a year. So, she now earns .₹ 5,18,400 and moves to the higher bracket to pay taxes at 20% on in­come over .₹ 5 lakh. The mar­ginal tax rate works out to be12%. Which means that ‘bracket creep’ has the in­di­vid­ual pay­ing a greater pro­por­tion of her 8% in­crease in in­come as taxes.

How­ever, if we now ac­count for the rise in price lev­els and in­dex the tax brack­ets, say, at 4%, then the .₹ 5,00,000 up­per thresh­old shifts to .₹ 5,20,000. This means that the in­di­vid­ual con­tin­ues to pay taxes at the same mar­ginal rate of 5% on .₹ 5,18,400, in­stead of on the mar­ginal rate of 12% if the brack­ets were not in­dexed. Clearly, then, an in­fla­tion-in­dexed tax bracket leaves the in­di­vid­ual bet­ter off, while at the same time, main­tains the pro­gres­siv­ity of the tax sys­tem.

One of the first coun­tries to in­tro­duce tax bracket-in­dex­ing was Canada in 1973. Fol­low­ing dou­ble-digit in­fla­tion dur­ing1974-81in the US, Pres­i­dent Ron­ald Rea­gan an­nounced the Eco­nomic Re­cov­ery Tax Act in1981, which al­lowed tax brack­ets to be ad­justed for in­fla­tion. Cur­rently, most coun­tries don’t have in­fla­tion-in­dexed tax brack­ets.

So, if bracket-creep makes the tax sys­tem less pro­gres­sive, then why is in­fla­tion-in­dex­ing not part of the tax pol­icy in most coun­tries? The an­swer lies in trade-offs. While in the­ory, an unin­dexed tax sys­tem acts as a hid­den tax, and al­lows tax col­lec­tions to in­crease over time with­out any change in tax rates or low­er­ing of the tax brack­ets, in prac­tice, tax­pay­ers tend to bunch below the thresh­olds, so the rev­enue gains from the hid­den tax are lim­ited.

Thus, pol­i­cy­mak­ers may de­cide not to in­dex the tax brack­ets at any level, since tax eva­sion at all thresh­olds will con­tinue. Busi­nesses also may not favour in­dex­ing the tax brack­ets, as work­ers may de­mand higher wages when prices in­crease lead­ing to high- er labour costs. In the longer run, in­creas­ing labour costs may make an econ­omy less com­pet­i­tive glob­ally.

In In­dia, two-thirds of those who file per­sonal in­come taxes lie in the zero-tax bracket, or the first tax­able bracket, cur­rently taxed at 5%. This sec­tion is also most vul­ner­a­ble to bracket creep. In­fla­tion-in­dex­ing, hence, would not lead to sig­nif­i­cant rev­enue loss from this lower tax bracket, while at the same time, it would make the tax sys­tem more eq­ui­table and pro­gres­sive.

In­fla­tion-in­dex­ing has pos­i­tive spillovers at the lower end of the labour mar­ket. There is a greater in­cen­tive for ex­ist­ing work­ers to work more (at the ‘in­ten­sive mar­gin’) or new work­ers to join the labour force (at the ‘ex­ten­sive mar­gin’). This would lead to an in­crease in GDP and wages, which, in turn, would con­tinue to keep the tax sys­tem buoy­ant.

Gov­ern­ments may also take into ac­count the ero­sion of real in­come due to in­fla­tion and re­duce the tax rates, par­tic­u­larly at lower thresh­olds. For in­stance, the re­cent Union Bud­get for 201819 re­duced the tax rate on the .₹ 2.5-5 lakh tax bracket from10% to 5%. Re­duc­ing the tax rates on ex­ist­ing tax slabs also works on the same prin­ci­ple as in­fla­tion-in­dex­ing, and makes the tax sys­tem more pro­gres­sive.

The writer is chief di­rec­tor, Tax Pol­icy Re­search Unit, Min­istry of Fi­nance, GoI

Brew­ing com­pli­ance

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