Why do so few individuals in India pay income tax?

Tax is a crucial source of money for governments. Taxes are collected in two ways: directly and indirectly. Direct tax is levied on individuals or businesses based on their income or profits, whereas indirect tax modes include GST, customs duty, and tax deducted at the source.

The total ITRs filed till July 31, 2022, for assessment year 22-23 is about 5.83 crore. "The surge of filing ITRs peaked on July 31, 2022 (due date for salaried taxpayers and other non-tax audit cases) with over 72.42 lakh ITRs being filed on a single day," an official statement said. 

While initially income tax return (ITR) filing was slow, the pace picked up as the deadline neared.

Last fiscal year (2020-21), around 5.89 crore ITRs (Income Tax Returns) was filed by the extended due date of December 31, 2021.

Meanwhile, India has a population of almost 136 crore people and it is the world's second-largest country after China. When it comes to filing taxes, however, barely 5% of the whole population has done so in FY22. This all boils down to one question: why are so few Indians paying taxes? Is it true that only a small percentage of the population bears this enormous burden?

Furthermore, India has a low tax-to-GDP ratio of between 10% and 12%, which is significantly lower than the emerging market economy average of 21% and the OECD average of 34%, according to media reports.

Is the large disparity in these data indicative of the widely held belief that most people do not pay their taxes? Let's have a look at the reasons for this.

Agriculture dependent economy

India is still a developing economy, with the bulk of the population falling into the medium-income bracket. As a result, the tax structure is organised in such a way that it does not impose too much burden on the people.

Meanwhile, India follows a progressive tax system where tax rates increase as income goes up. To put it simply, the greater the income, the higher the tax rate.

According to CMIE data, the labour force in India increased by 88 Lakhs from 42.84 crore in March 2022 to 43.72 crore in April 2022, ET reported. 

The increase in employment in April was in the industry and in services. While industry added 5.5 million jobs, services added another 6.7 million jobs in April. The agricultural sector, however, shed 5.2 million jobs on the back of the winding up of the rabi season and the decline in wheat production.

However, the agriculture sector employs between 40 and 45% of the workforce in India, with the remainder distributed almost evenly among the other sectors, industry, and services.

Agriculture is generally the only source of income for India's massive rural population. The government has a number of plans, laws, and other measures in place to encourage growth in this industry, one of which is an exemption from income tax.

As per section 10(1) of the Income Tax Act, agricultural income earned by the taxpayer in India is exempt from tax. Agricultural income is defined under section 2(1A) of the Income-Tax Act.

This clearly shows that 40-45 per cent of the overall labour force is tax exempt because they work in the primary sector. When it comes to the remaining 55–60% of the workforce, only those earning more than five lakh rupees are required to pay tax in India. How many Indians earn more than around ₹5 lakh to be eligible to pay income tax? India’s per capita income is around ₹1.5 lakh (current prices), meaning that an average Indian earns ₹1.5 lakh per year. The basic exemption threshold is almost three times the average per capita income, so a major chunk of the population is not liable to pay taxes.

To put this in context, in major countries, the basic exemption limit is set lower than the average income, resulting in a larger tax base.

So India's income tax base is low not because people are stashing money on their roofs or beneath their mattresses, though some may be. However, because the average Indian income is well below the baseline exemption amount.

In addition to that, at constant prices, India's annual per capita stands below the pre-covid levels at ₹91,481 in FY21-22, according to the Ministry of Statistics, and India ranks 130th in per capita income out of 189 countries, with only other South Asian and African countries ranking lower.

Widening Inequality

India’s high-income inequality implies that only a small fraction earns more than the per capita income. The World Inequality Report 2022 shows that India’s top 1 per cent account for 22 per cent of national income, while the top 10 per cent get 57 per cent of the income and the bottom 50 per cent share 13 per cent of national income.

The average national income of the Indian adult population is ₹2,04,200, which is below the tax exemption limit.  Here, the bottom 50% earns ₹53,610 while the top 10% earns ₹11,66,520, over 20 times more. The report further says that private wealth in India went up from 290% in 1980 to 560% in 2020.

Apart from that, 2016 played a significant role in eliminating tax evasion due to demonetisation tax collection, the government added 9.1 million new taxpayers in 2016-17 an 80% increase over the typical year rise. India had only 55.9 million individual taxpayers at the end of 2015-16, Mint reported.

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