What Would Happen if The Income Tax Were Abolished

Manan had toiled for 3 hours in his neighbour’s garden shortening the grass to earn ₹200 for his services. As he returned home with his hard-earned money, his mother took ₹50 from his earnings and gave it to his younger brother who didn’t earn anything. This is essentially how an income tax system works. It takes away money from the hands of income-earners and that money is used for the betterment of the poor and public as a whole. Adding further to such a seemingly inhumane practise, the people who earn the highest, that is, the people who put in maximum effort and are prone to maximum risks are subject to the highest tax slabs in the country. Such a tax system inherently disincentivises putting in greater effort and improving earning capabilities. The system of income tax is not restricted to individuals as even corporates are subject to high taxes on their profits, thereby inhibiting their growth. Not until long ago, the Dividend Distribution Tax, a major deterrent towards the distribution of profits among shareholders, had plagued the industry.

The Disincentives and Criticisms of Income Tax: Implications for Economic Growth and Liberty

Taking away a part of the value earned by individuals through their skill and hard work not only disincentives them from undertaking more productive activities contributing to the growth of the economy but also leads to them coming up with ways to hide their true incomes and escape paying taxes. The progressive nature of the income tax regime, though appreciated by those at the lower rungs of the income ladder, is looked at with contempt by the rich since it treats their increased efforts with an increased rate of tax and takes away a greater portion of their earnings. Many critics of a tax on income point out how income taxes seem to breach the individual’s liberty and create a complicated mechanism of maintaining and filing proper documents that are, in turn, subject to scrutiny by government officials. Moreover, a tax on income excludes a lot of citizens in the country from contributing to the government coffers. For instance, in India, only 2.5% of the total number of citizens are reported to pay income taxes. Moreover, 60% of the total revenue received by the government from a tax levy on income is paid by just 4% of those who pay.

Considering the various shortcomings in the Income Tax system, there’s a contention among many government officials to remove this system and shift to an entirely new regime. However, this process cannot be undertaken as a knee jerk response to the disadvantages of the Income Tax. The population of India has been used to the current tax regime since independence and a sudden shift may result in mayhem. Moreover, a major disruption such as this shall serve as an impediment to India’s growth trajectory delaying the fulfilment of its dream of becoming a developed economy. Instead, a slow transitionary approach will have to be adopted by the government where it shall start reducing the tax rates on income, giving the people time to adjust to the change. A pertinent question with such a reduction in tax rates is that of the loss of revenue for the government, given that roughly 50 % of the government revenue is raised through direct taxes. The most plausible answer to this question would be a gradual shift to a consumption tax-only regime.

A consumption tax is one which taxes individuals at the point of using their income rather than the point at which it is earned. In our example, if Manan’s mother had taken ₹50 from him when he had used the ₹ 200 to purchase something, then that would have been an example of a consumption tax. Such a tax by nature incentivises people to earn more as they will only be taxed when they use their income. This type of tax makes consumption less desirable and promotes savings. As such, this results in higher savings and hence, higher investments. The corporates also find it easier to raise risk capital as people are willing to invest more since their income from dividends will not be taxed. A consumption tax eliminates the concepts of Corporate Tax, Dividend Distribution Tax, Long Term Capital Gains Tax and Short Term Capital Gains tax. As a result, a consumption tax has the potential to boost business activity in the economy.

Changes in Tax Base, Effects on Corporations, Government and Individuals

The removal of the Income Tax shall not be an easy task with widespread implications for various stakeholders. Now, if we assume that the government has been able to successfully abolish the income tax, there shall be humongous changes in the tax regime. Perhaps, the most significant change shall be in the size of the tax base. Under the new consumption tax, all will have to pay taxes regardless of their income level. While the income tax was levied on the residents of India, the consumption tax would have to be paid by all, both residents as well as foreigners, who conduct purchases within the domestic territory of the country. Moreover, while agricultural income is exempted under the income tax regime, a tax on consumption might add to the adversaries of Indian farmers.

While analysing the implications of the removal of income tax on the Indian economy, we need to consider its effects on three major stakeholders: the Corporations, the Government and the individuals.

Removal of tax on corporate earnings is bound to make business houses rejoice about the increased money left in their coffers. Corporate tax indirectly incentivises businesses to retain or plough back their profits back into the business to escape paying taxes and later on, leaves them with the only feasible option of capitalising on their accumulated profits by issuing bonus shares. Removal of corporate tax would hence, encourage more frequent and higher rates of dividend payouts. Increased payouts of a dividend would, in turn, lead to an increase in both savings and consumption in absolute terms. However, in relative terms, savings and income may or may not increase simultaneously.

As far as individuals are concerned, a majority of Indians might not be affected by the removal of income tax since according to government records, only a small fraction of the Indian workforce pays income tax. The middle-class and the rich would be incentivised to undertake more productive activities with an assurance that a major part of their increased income would not be taken away as a result of their increased burden of tax payments.

The government would be left grappling for funds if the abolition of the income tax is not carried out systematically since presently, a major part of the government revenue comes from direct taxes rather than indirect taxes. A gradual shift towards the consumption tax regime shall enable the government to increase its tax base manifold. The government will have to increase the number of items it taxes as well as the tax rates on some goods. This would ideally result in higher tax collections for the government which it can use for developmental purposes. The removal of Income Tax shall also result in the reduction of physical facilities required for running the tax regime. For Instance, the Central Board of Direct Tax shall become a thing of the past and a major chunk of officials from the Finance Ministry will lose their jobs. However, on the upside, by removing all personal taxes, the government would have practically eliminated all black money. With no income tax, people will have no incentive to hide their income and bank deposits will skyrocket. Interest rates will plummet and the financial markets shall expand to great lengths.

Possible Outcomes for Corporate Sector and Economy

An analysis of the implications of implementation of Consumption tax on these three major economic entities along similar lines becomes imperative to fairly compare the advantages and disadvantages of substituting Consumption tax for Income tax.

The regressive nature of a consumption tax regime would arouse discontent among the poor. This change might also go against the canon of equity since the poor might find themselves in a worse off situation than the rich. While the rich would appreciate this move, the poor would be worst affected. Despite an increase in the price the rich would have to pay for goods and services, removal of income tax would increase their disposable incomes. While there would be no significant change in the disposable incomes of the poor (since their incomes were not taxed even during the income tax regime), they would have to pay higher prices for the goods and services they purchase. This would drastically increase their expenditure with no change in their disposable incomes, thereby reducing the amount they can save.

The corporate sector would not be much affected by this change in parameter for tax levies since an increase in the cost of raw materials and other services would be offset by an increase in the income left at their disposal. However, due to an increase in the market price of their goods, certain changes might be observed in their demand, depending upon on the nature of the goods as well as the elasticities of their demand.

The government would see a significant increase in the number of people contributing to its revenue than during the income-tax regime. Moreover, an implementation of this tax would help reduce administrative costs for the government since this system shall be mostly administered via digital means (such as the current GST System) and no expenditure shall be incurred on hiring scores of Chartered Accountants, Company Secretaries and Cost Accountants. This significant drop in the cost of collecting taxes shall lead to higher government revenues, despite the new schemes which the government might need to undertake to uplift the poor to compensate for having introduced a regressive consumption tax system.

In the context of the Indian economy, removal of income tax and implementation of a consumption tax would come with its own set of problems. When the time is finally ripe, it’s better to phase out income tax and introduce consumption tax gradually, allowing people to adjust to this change. Categories of goods, keeping in mind their nature and elasticity of demand, should be made and assigned suitable rates of taxation.

The government will have to appease the public backlash arising from a rise in market prices of goods and services and prevent this major reform from serving as an impediment to India’s growth. Given that a significant part of Indian markets comes under the ambit of the informal sector where purchase and sale transactions are seldom recorded, establishing accountability and transparency as well as regulating and maintaining proper transaction histories for calculation of tax liabilities would prove a herculean task for the Indian government. For instance, making road-side vegetable vendors maintain proper purchase and sale records and deposit the due taxes in government accounts requires these vendors to be well-apprised of the intricacies of this mechanism. Such a system might also lead to the rise of black markets and the underground economy where the trade of commodities takes place, hidden from government authorities.

Conclusion

To conclude, a system that solely levies a tax on consumption to serve as the main source of funds for the government has its own merits and demerits. Implementation of such a system becomes easy in a developed country where almost all transactions take place in the formal sector and are thus, properly regulated and recorded. However, the introduction of a consumption tax in a developing country like India brings forward a unique set of challenges. Even if we are able to devise a system to record all transactions in the unorganised sector, the consumption tax shall lead to a rise in prices of all goods, which will lead to a more than proportionate reduction in demand as most of the people in India belong to the low earning group and spend most of their income on current consumption. Moreover, these people wouldn’t be much affected by the removal of tax on income. The cycle will continue ultimately resulting in a fall of production (and thus national income). However, if viewed from a different perspective, the consumption tax essentially removes tax from investment and promotes business activity as well as increases savings. This increase in business activity and savings would lead to an expansion in the economy and result in an increased national income, which shall, in turn, stimulate demand and set a cycle of income, demand and production into motion.

The government may introduce the concept of universal basic income, raising the minimum guaranteed amount for all individuals. This would require the government to make direct money transfers to the poor to ensure that they can afford at least the necessities of life at the increased prices. On the other hand, the government can utilise the existing rationing system to provide the poor with essential goods at subsidised prices.

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