Column : What constitutes income

Written by R Kavita Rao | DP Sengupta | Updated: Jan 22 2013, 06:07am hrs
Part B TI of the Income Tax Return (ITR 4) form gives the details of computation of total income. It captures information relating to income from the five different heads, namely salary, income from house property, profits and gains from business or profession, capital gains and income from other sources. Let us call this A. The aggregate of such incomes as reduced by current and brought forward losses gives the gross total income, say B. From the latter, the deductions as available under chapter VI A are reduced and we arrive at the total income for the purpose of income tax, say C. It is evident that this form of capturing total income involves three constructs of incomethe sum of the different heads, gross total income and total income. These constructs of income used by the income tax department in its statistics are obviously different from the income as would be understood by an economist.

From an economists point of view, an exempt income is an integral part of the income of the tax payer. However, the exempt incomes will not enter into the computation of any of the above constructs of income. Second, each of the heads of income has its own set of deductions. For example, the computation of the income from house property provides for deduction for maintenance or property. In the case of a self-occupied property, while the rental income will be nil, deduction of interest paid on loan-financed property will be available, which will then go to reduce the total income. Similarly, house rent allowance, although a part of the salary income, would be excluded fully or partly by virtue of the exemption provided in section 10 (13A). In case of business income, benefits from accelerated depreciation are already incorporated when the income from business is computed. The examples can be multiplied. Further, the economists definition of income will also vary in so far as treatment of brought-forward losses as also the deductions relating to encouragement of savings and investment are concerned.

While analysing the income and tax data provided by the income tax department, therefore, it is important to understand which definition of income is being referred to and what can be inferred from the same. Two columnsThe taxation silly season is here ( and Blinded by tax revenue ( raised some interesting issues with respect to income taxation, veracity of data and effective tax rate faced by the different income categories. Both the columns refer to data given by the Standing Committee Report on the Direct Taxes Code submitted in March 2012.

In order to begin analysing the data in the Standing Committee Report, it is essential to decide which definition of income has been used to classify the returns. Let us assume that C defined above is used. In such a case, for calculation of tax, the only step left is application of the tax rates at the relevant tax slabs. Clearly, apart from the impact resulting from any progressivity of the tax system, there should be no difference between the average effective tax for the different income categories.

From the figures reported in the Standing Committee Report, we can derive an average tax paid for each of the categories and corresponding to this the average income based on tax rates too can be computed. It may be noted that the income tax slabs underwent significant change in 2010-11. The Standing Committee Report is based on estimates for the year 2011-12: since the report was submitted in March 2012, and reports interactions with the revenue department in 2010, it is fair to expect that the data provided to the Standing Committee would be projected from information available for the year 2009. The change in the tax slabs results in a reduction in the tax liability corresponding to any given income. In the accompanying table, income 1 is computed using tax slabs for 2009 while income 2 has been computed using tax slabs for 2010-11. The table illustrates the difference: average income 1 and effective tax rate 1 relates to tax slabs in force for 2009-10 and average income 2 and effective tax rate 2 pertain to 2011-12.

What should be noted is that while for the first two categories, the average income computed lies in the specified range (R0-5 lakh and R5-10 lakh, respectively), the average income for the third category lies outside the range, since it is less than R10 lakh. The table being based on the application of statutory tax rates alone, the average income so derived should lie in the specified range if the range is based on the definition of income referred to as construct C. This suggests that the definition of income used for constructing the ranges is either construct A or construct B.

If, for instance, construct A is used, then the relation with the taxes collected is no longer straightforward, and gets skewed by the chapter VIA deductions and set-off of losses. This might explain the deviation of income computed from the ranges. As assumed by the columns mentioned earlier, if we too assume that the average in the income range is the mid-point, then the deductions for the income range R10-20 lakh would be to the tune of R7.5 lakh per returnall from provisions enshrined in the Income Tax Act.

Interestingly, if similar deductions are available to the highest income class too (over R20 lakh), the current analysis would mean that the incomes of the highest income category would be even higher than the R79 lakh reported above! If these numbers are compared with the figures in Kelkar report on direct taxes, it would suggest a substantial increase in inequalitythe ratio of income in the lowest category reported here to that for the highest category having increased from 15 times to over 39 times! If the highest income is also adjusted for deductions/losses, the ratio would be even higher.

The numbers reported in the Standing Committee Report can be suspect but, if not, then they suggest a very sharp increase in inequality in the country. This conclusion seems to be broadly in line with other studies which report doubling of inequality in the last decade.

And most important, the above does not provide a basis to argue as to whether rich are paying high taxes/enough taxes or not since we do not know the corresponding economists version of incomes for any of these categoriesthe total earnings net of expenses incurred towards these earnings!

The authors are with the National Institute of Public Finance and Policy, New Delhi