Not Just Indian Exceptionalism: The Moral Case For Abolishing Income Tax

In a column yesterday (8 December), a case was made out for the abolition of income tax on individuals and shifting the burden of raising state revenues to indirect taxes and a bunch of other transaction levies and cesses. The primary argument was based on the average Indian’s cultural aversion to paying out direct taxes.

However, there is an even stronger moral case for abolishing income tax for individuals.

The problem with taxing individuals is that the costs that go into earning that income seldom get amortised. When you tax a corporation or business, the costs and investments incurred in running that business are deducted from revenues and only the surpluses (profits) are taxed.

Now consider the case of an individual. To make an individual capable of earning an income, the invested costs from birth to working age are enormous. It can take anything from 14-25 years to make an individual productive. None of these costs are deductible from the income an individual earns. If the logic of deducting costs before taxation is valid for companies, why not individuals? Since it is impossible to arrive at these costs, which can vary from individual to individual, the second-best way is to not tax individual incomes, whether earned by physical work, mental work, or a combination of the two.

Then there is the question of tax inequity. I am not the first one to point out that almost anywhere in the world, labour income is often taxed more than capital-based income. Rajiv Shastri of Pramarica Asset Managers made this point some time ago in Firstpost, and many more people have also done so.

Ace investor Warren Buffett has pointed out that as an owner of a business, his tax rate is lower than that of his secretary. This is because income earned from investing capital is often taxed at a lower rate than income earned from employment.

In India, long-term capital gains attract zero tax. And dividends are taxed at a lower rate than incomes in the highest bracket. Interest paid is a deductible item in business, but interest paid by individuals (whether paid for buying a home or to own a car) does not get this kind of tax break (except for interest payments on home loans upto Rs 2 lakh).

To correct the tax handicap suffered by individuals as against businesses, the logical way is to abolish income tax for individuals, with taxes kicking in only after high levels of income are achieved (say, above Rs 1 crore per annum). Even here, it should be a flat tax. Individuals earning interest income and dividends from accumulated capital can be subject to tax deduction at source at moderate rates of, say, 20 per cent.

The third moral argument to abolish income tax on individuals is even simpler: you cannot make millions of hard working Indians criminals by calling them tax evaders. In the last few days, one has heard anecdotal stories of Ola and Uber drivers earning Rs 50-80k a month by working over-time and at odd hours. A maid working for Rs 3,000 each in 8-10 houses would also be in the taxable bracket. But the thought that they may be tax evaders may not even have crossed the minds of the Ola driver or our maid. It is wrong to make hard working people tax criminals. That is something you do only to the super-rich, not the aspiring or middle classes.

Now, let’s take the people at the other end of the spectrum: those who earn very high incomes, and have huge surpluses to invest and earn even more. Entrepreneurs can accumulate millions over a lifetime, and some could be billionaires, some of it created from tax-free incomes.

There is thus a case for taxing high levels of inherited wealth and incomes earned from idle investments: it is one thing to not tax incomes accruing directly from individual work, quite another to treat incomes from passive investment (money earning money) as tax-free. Clearly, dividends, capital gains and interest incomes must be taxed. A flat tax, of say, 20 per cent, would be ideal here. And inheritance taxes, after a generous tax-free limit of, say, Rs 50 crore, can be subject to 30 per cent tax, unless the entire balance accumulated wealth is invested in trusts focused on charity or social causes like building schools or hospitals.

The fourth, and most important, moral case for abolishing income tax is – debatably – the need for a smaller and more effective state. If you believe in the idea of a small state, and maximum freedoms to individuals, it follows that more money must remain in the hands of citizens and less with the state.

The Indian state is simply too big and tries to do too much and does not do anything well. Not even defence of the country. Trying to shift money from citizens to state is one reason for wasting more national resources. The justification for a bigger state is that the poor need safety nets, but this is tosh: the state must facilitate the transfer of resources to the poorest, but it does not follow that the state must itself do this job by taxing the better off.

The state must create policies and structures where the wealth of the rich and the better off starts flowing in socially-enriching directions. This can be done through enabling legislation and tax incentives for providing safety nets, social services, charitable schools and hospitals funded through private wealth and initiatives. This is one reason that justifies the imposition of an inheritance tax on holders of extraordinary wealth.

The state must shrink to be effective. By trying to do too much, it does too little. It should be an enabler, and not a disabler. Leaving money in the hands of income earners rather than expropriating it is one of the best ways of doing this.