It is time India started indexing tax slabs and exemptions with inflation

The personal income tax collection (excluding securities transaction tax) stood at ₹4,52,286 crore in April-August 2024-25, up 25.5% from ₹3,60,381 crore in the year-ago period. Hopefully, it should lead to a more stable and equitable tax base for India.

As the government’s revenue from personal income tax rises, it will likely face greater scrutiny and higher taxpayer expectations regarding the tax system's efficiency, transparency, stability, and fairness. Some of these sentiments came through as the government brought about the rationalization of capital gains taxes.

Indian tax system

Interestingly, the growth in these collections has also coincided with significant changes in India’s personal tax system. The Indian tax system is primarily divided into two categories: the old tax regime and the new tax regime. The old tax regime evolved over several decades, allowing individuals to claim various deductions and exemptions under different sections of the Income Tax Act, 1961.

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The new tax regime, introduced in the Union Budget 2020-21, offers a simplified tax structure with lower tax rates for the same income level but does away with most exemptions and deductions. The new regime was made the default tax regime in 2023, though it remains optional for individuals (especially the salaried class). The new regime is simpler and makes it easier to comply without making it burdensome on the taxpayers.

To encourage the adoption of the new personal tax regime, the budget 2024 rationalized the tax slabs to provide additional tax benefits up to a maximum of ₹17,500 (excluding surcharge and cess). The standard deduction has been increased to ₹75,000, and the deduction for the employer’s contribution to the national pension scheme has been increased from 10% of basic salary to 14%.

With economic growth, we are likely to see an increase in the tax base as more and more people earn incomes that make them eligible to pay taxes. For the lower-income segment of taxpayers, a significant portion of income is spent on basic necessities like food, housing, and healthcare, which witnesses high inflation, especially food items. With inflation, real incomes come down with time. However, our tax slabs are not set on real incomes and are set on nominal incomes.

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There is no measure currently in India where the slabs or the exemption limits increase with inflation. Though the government revises the slabs and exemption limits, like the increase in the standard deduction to ₹75,000, it is difficult to discern a pattern and consistency.

The government could consider taking a leaf out of tax slab adjustments done by some of the developed economies. The US adjusts income brackets upwards annually by factoring in the annual inflation. Similarly, countries like Germany, Finland, Sweden, and Norway take into account the cost of living index to adjust the income slabs every year for the purpose of taxation. Austria, in 2023, introduced an automatic inflation adjustment mechanism. These measures give more certainty and transparency to taxpayers and allow their income to rise in a real sense by automatically making an inflation adjustment to the income levels which are subject to tax.

Inflation in India can be measured in multiple ways, but the consumer price index (CPI) is the widely used matrix in India by policymakers, including the Reserve Bank of India, to track changes in the prices of the basket of goods and services consumed by households. When the CPI rises, it indicates an increase in the cost of living as inflation erodes the purchasing power of consumers, thus making it difficult for households to maintain their standard of living.

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Thus, while the tax reforms and rationalization of tax slabs under the new tax regime in the 2024 budget have been a welcome move, the lens of inflation may be applied in the future to meet the changing needs of the economy and the aspirations of its citizens.

Rajnish Gupta is a partner-tax and economic policy group, and Shalini Jain is a tax partner at EY India.