Income tax is worth abolishing. The gains may be more than losses once it is done well. The BJP would be wise to take the plunge and not tinker at the edges of tax reform

For the first time, the BJP's prime ministerial candidate has spoken directly on an economic issue. Speaking at function organised by yoga guru Baba Ramdev in Delhi yesterday (5 January 2014), Narendra Modi promised a substantial reform of the tax system which "is a burden on the common man. There is need to reform it. It is the need of the time."

Is the promise for real? After all, don't all governments and budgets tinker with the tax system and call it "rationalisation" or "reform"? The hint that Modi gave to indicate that he may be doing more than just the usual fiddling came when he said: "If the present system is to continue, what is the point of my coming here?"

Quite. The BJP's top brass has been making radical noises about the abolition of income, excise and sales taxes in its vision document, but it is highly unlikely that we can expect so many drastic changes in a July budget, assuming the BJP comes to power. Moreover, changes in excise and sales taxes need the concurrence of states, while income tax is entirely the centre's domain.

There is little doubt that some radical measures have to be announced before the election so that it has some impact on the vote. More importantly, for an economy stuck in stagflation, fooling around at the edges of the tax system is hardly what the doctored ordered. Something more substantive is required.

The big impact tax in terms of the aam aadmi's psyche is personal (non-corporate) income tax, and there is no reason why the BJP should not seek its total abolition both to energise the middle class and to make the economy turn around.

Let's be clear: income tax is largely a tax on the middle class salary earner and no other class, though we should include professional, non-salaried people too in it. The poor don't pay any income tax, and the rich get a big chunk of their incomes from dividends and capital gains - very little from salaries.

Finance Minister P Chidambaram said in his last budget that just over 42,800 people have declared taxable incomes of over Rs 1 crore annually. Another statistic: 63 percent of the total taxes collected from individuals comes from just 400,000 people earning more than Rs 20 lakh.

In sum: out of India's taxpaying base of around 35-40 million, only 1 percent accounts for the bulk of the tax collections. Put another way, 99 percent of India's taxpayers are being forced to file returns and pay paltry amounts of taxes for no good reason. It is harassment and hassle without purpose.

Even among the 4,00,000 who do pay more taxes, it's largely because they can't evade it. The taxes are probably deducted from salaries or other incomes and collected at source.

The case for abolishing income tax, or at least modifying it substantially, is simple: it is unfair because only one important class is an easy pick; it creates a huge need for paperwork both at the corporate end and at the taxpayers' end; the deductions given on taxes (80C, etc) drive savings to areas that are tax-efficient rather than for meeting the real needs of taxpayers. (Ask yourself, do you buy insurance as risk cover for life or the tax-break in March?)

Income tax also makes criminals out of many of us. It forces both employers and employees to cheat. As for other non-corporate taxpayers - professionals (doctors, lawyers, etc), firms (non-corporate), associations of persons (AoPs), or bodies of individuals (BoIs), these categories are possibly more capable of evading tax and vulnerable to corruption.

Non-corporate income tax is also an indirect hindrance to job creation. If companies know that there is no income tax, they can recruit new employees at lower salaries without reducing an individual's tax-home pay. This will bring down wage bills and encourage companies to hire more. If coupled with easier labour or contract labour laws, employment generation will explode.

But wait, you may ask: how will the government recoup the tax losses? In the 2013-14 budget, Chidambaram had pencilled in personal tax revenues of Rs 2,47,639 crore - roughly a fifth of total revenues. How will the loss be recouped?

Many ways, really.

One, when income tax is abolished, there will be no deductions too. The costs of tax administration and tax compliance will come down. The government will need less tax revenues. Moreover, the current catchall head of "Taxes on Income" includes earnings from securities transaction tax, which need not be abolished.

Two, non-corporate income tax is earned from two basic sources - individuals (who earn it as salary, interest, dividends, property income, capitaql gains, etc) and firms (assessees who earn business incomes). If, in the first instance, income tax is abolished only for those not earning a business income, then the tax loss will be much less. However, it is best to exempt business income too - for this is the real sector that creates huge jobs through self-employment and setting up productive unincorporated businesses. In 2011-12, non-corporate firms, AoPs and BoIs together yielded less than Rs 20,000 crore in taxes. Not exactly a huge cache for the finance minister to tap. On the other hand, the corruption potential in this group of nearly 5,68,194 assessees (in 2011-12) is enormous. Spare them the tax heart-burn, and this sector could employ more and create more jobs.

Three, as companies will end up reducing labour costs over time, one can also start withdrawing their tax breaks. On direct taxes alone, the net taxes forgone were Rs 68,000 crore 2012-13, according to the finance ministry. Eliminating the major ones would save at least another Rs 40,000 crore in one or two years.

Four, when incomes rise due to zero income taxes, demand will sprout. This means taxes from excise and customs will balloon as the economy picks up steam. Since the tax abolition will benefit the taxpaying classes directly, the demand will flow directly to the manufacturing and services sectors - two sectors with lower inflation than food.

Five, a part of the loss on income taxes can be made up by higher value-added taxes, especially the new goods and services tax (GST). Between them, excise, customs and service taxes are budgeted to yield over Rs 5.6 lakh crore in 2013-14. A one or two percent hike will yield another 50,000-100,000 crore in indirect taxes.

Six, the government simply has to cut subsidies to the middle class. Right now, subsidies on diesel, LPG and kerosene add up to over Rs 1,50,000 crore. If only one-third of this is paid out to the poor for LPG and kerosene, the entire tax blow on eliminating income taxes would be taken care of. Subsidies will be easier to cut if income tax is abolished altogether.

There is talk of replacing income tax with an expenditure tax, where money flowing out of bank accounts will be taxed. This will need to be thought through, but this would be another way to fix the tax hole over time.

However, there is no doubt that eliminating income tax will rejuvenate the economy and reduce tax hassles at the level of the taxpayer.

Unlike promises of free water or cheap electricity, which can only increase corruption, the abolition of income tax is a reform that will actually make taxpayers more honest. It will eliminate a huge area of corruption and falsehood while also serving as an economic stimulus to a stagflating economy.

If I were Narendra Modi, I would go for it. It would energise his constituency like nothing else. Even if he wants to play cautious, there is a step-by-step way of doing it. In year one, abolish taxes for those earning less than Rs 20 lakh - this will reduce tax earnings by only a third of the current amounts earned. If this works, he can abolish it for those earning upto Rs 1 crore and then for everybody.

Timidity is not needed anymore.

(Note: This is an updated and corrected version of an earlier piece based on feedback and criticism. The main change relates to an acknowledgement that income tax is not only about salary earners, though they are the ones least able to evade it. The story also updates categories of non-corporate taxpayers, including firms, associations of persons and bodiesof individuals, who would also benefit from an abolition of tax).