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Inflation has often been described as taxation without representation. Governments all over the world have used the printing press as a magic wand that produces wealth at no short-term cost. This article describes the way in which governments affect real increase in taxes without increasing them nominally. Inflation acts as a faithful ally of the ruling dispensation in extracting extra taxes from the working population. Indexation of tax slabs, as suggested by Nobel Prize winning economist Milton Friedman, can work as an effective antidote and save the hapless taxpayer.

Let me explain the phenomena with the help of a simple example: Imagine an economy where income up to 5 lakh is not taxed and any income above 5 lakh is taxed at a flat rate of 20%. In this economy, a person with an income of 10 lakh ends up paying a tax of 1 lakh, which effectively works out to be 10% of her income. Thus, the take-home income of the person works out to be 9 lakh. Now imagine that after a year, prices of all goods and services (including wages) go up by 10%. Our taxpayer will now have an income of 11 lakh. If the tax slabs remain the same, she ends up paying a tax of 1.2 lakh (10% of 11 lakh minus 5 lakh), and takes home 9.8 lakh. In nominal terms, her take-home income increases from 9 lakh to 9.8 lakh. But does this mean that there has not been any increase in tax? Many people may think that the taxpayer is better off now. But further analysis makes the point clear.

Now imagine that during the first year, the basket of goods and services consumed by our taxpayer costs 9 lakh. In the next year, if the she wants to maintain the same standard of consumption, she will have to spend 9.9 lakh. Remember that inflation rate is 10%. But as we have calculated above, the consumer has only 9.8 lakh to spend. Effectively, the government has imposed an additional tax of 10,000, and that too without having to amend the legislation. In other words, by not changing the tax slabs during inflationary times, the government effectively increases the real tax on the taxpayer.

Continuing the above example, now imagine that the government announces an additional tax relief of 5,000 in the second year. The finance minister will go overboard in the media claiming that even in difficult times, he has tried to help the middle class by reducing the tax burden. But in real terms, the taxpayer loses 5,000 compared with the previous year. Granted that this is better than losing 10,000, but it cannot be called a tax reduction.

To add insult to injury, our leftist friends are likely to protest against such a tax “reduction" as helping the rich at the cost of the poor! There cannot be anything more absurd than this.

The second mechanism by which the government extracts surplus taxes with the help of inflation is more subtle: Here, the mechanism is the upward movement of taxpayers into higher slabs only because of inflation. Let’s go back to the simple tax world that we created earlier. In the first year, there are likely to be a substantial number of people in the income bracket of 4.54 lakh and 5 lakh. They will be out of the purview of tax. So, a person with an income of 4,99,999 during the first year will not be taxed that year. Needless to say, her take-home income equals her taxable income. In the second year, her income is likely to be (assuming no real increases) 5,49,999. At the same time, the prices of the same quantity of goods and services that this person consumed in the previous year are also likely to increase to 5,49,999. However, as the reader would have guessed by now, the disposable income of the person is likely to be less than 5,49,999, because now she has to pay 9,998 as tax. Thus, the hapless citizen ends up sacrificing consumption because of the simple reason that inflation pushed her nominal wages up. The government is now able to tax even those who would have otherwise been not liable to tax.

It is important to note that the second, more subtle, effect pointed out is likely to harm people with low income levels more than those with high incomes.

The solution to the above problems is very simple: just index the tax slabs to a suitable inflation index. Suppose the tax slabs also go up to 5.5 lakh, then it is easy to see that in both the cases highlighted above, the taxpayer pays the same amount in real terms in both years and hence need not make sacrifice consumption. No taxpayer is likely to be brought into the tax net without any real increase in income.

The National Democratic Alliance government and its ministers have made the right noises so far regarding taxation policy. The finance minister has said that the “tax terrorism" perpetrated by the previous regime should stop. I strongly believe that indexing tax slabs to inflation is one way of doing so. Minor nominal changes in tax structure are unlikely to help the taxpayer substantially during inflationary times.

Prasanna Tantri is associate director of Center For Analytical Finance, Indian School of Business.

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