The recent announcement of the year-on-year growth in net direct taxes at 15.7% in the current fiscal year corroborates the buoyant trend in direct tax collections over the past few years, both due to an increase in the tax base as well as improved tax compliance.With such encouraging trends, it’s an opportune time to think of further innovations to make the tax system more responsive to economic fundamentals and enhance compliance. One way to do this is by inflation-indexing the tax brackets.This can potentially make for a more progressive tax system by minimising ‘ bracket creep ’ — the situation where a taxpayer’s income increases over time, but the tax rate thresholds remain the same, thereby possibly making him or her pay taxes at a higher rate due to entry into a higher bracket, even though in real terms, his or her income may not have increased.This may make the tax system more regressive, particularly for those close to the upper thresholds in each tax bracket. Consider an individual declaring a taxable income of Rs 4.80 lakh.Currently, she falls in the Rs 2.5-5 lakh tax bracket and pays taxes at a 5% tax rate. Now assume that this individual’s nominal wages increase at 8% a year. So, she now earns Rs 5,18,400 and moves to the higher bracket to pay taxes at 20% on income over Rs 5 lakh. The marginal tax rate works out to be 12%. Which means that ‘bracket creep’ has the individual paying a greater proportion of her 8% increase in income as taxes.However, if we now account for the rise in price levels and index the tax brackets, say, at 4%, then the Rs 5,00,000 upper threshold shifts to Rs 5,20,000. This means that the individual continues to pay taxes at the same marginal rate of 5% on Rs 5,18,400, instead of on the marginal rate of 12% if the brackets were not indexed. Clearly, then, an inflation-indexed tax bracket leaves the individual better off, while at the same time, maintains the progressivity of the tax system.One of the first countries to introduce tax bracket-indexing was Canada in 1973. Following double-digit inflation during 1974-81in the US, President Ronald Reagan announced the Economic Recovery Tax Act in 1981, which allowed tax brackets to be adjusted for inflation. Currently, most countries don’t have inflation-indexed tax brackets.So, if bracket-creep makes the tax system less progressive, then why is inflation-indexing not part of the tax policy in most countries? The answer lies in trade-offs. While in theory, an unindexed tax system acts as a hidden tax, and allows tax collections to increase over time without any change in tax rates or lowering of the tax brackets, in practice, taxpayers tend to bunch below the thresholds, so the revenue gains from the hidden tax are limited.Thus, policymakers may decide not to index the tax brackets at any level, since tax evasion at all thresholds will continue. Businesses also may not favour indexing the tax brackets, as workers may demand higher wages when prices increase leading to higher labour costs. In the longer run, increasing labour costs may make an economy less competitive globally.In India, two-thirds of those who file personal income taxes lie in the zero-tax bracket, or the first taxable bracket, currently taxed at 5%. This section is also most vulnerable to bracket creep. Inflation-indexing, hence, would not lead to significant revenue loss from this lower tax bracket, while at the same time, it would make the tax system more equitable and progressive.Inflation-indexing has positive spillovers at the lower end of the labour market. There is a greater incentive for existing workers to work more (at the ‘intensive margin’) or new workers to join the labour force (at the ‘extensive margin’). This would lead to an increase in GDP and wages, which, in turn, would continue to keep the tax system buoyant.Governments may also take into account the erosion of real income due to inflation and reduce the tax rates, particularly at lower thresholds. For instance, the recent Union Budget for 2018-19 reduced the tax rate on the Rs 2.5-5 lakh tax bracket from 10% to 5%. Reducing the tax rates on existing tax slabs also works on the same principle as inflation-indexing, and makes the tax system more progressive.