Over the past few years, the Indian tax system has seen a series of reforms aimed at streamlining the compliances and widening the tax base. These changes have been critical in shaping the country’s economic landscape and have had varying impact on different aspects of taxation. For the salaried taxpayers, one of the major changes came in the 2020 Budget when a new and simplified optional tax regime was introduced with lower tax rates but without the benefit of most deductions and exemptions such as exemption for house rent, deduction for home loan principal and interest on self-occupied property, contribution to provident fund, payment of life insurance and health insurance premia etc. Taxpayers have been given an option to select the preferred tax regime (new tax regime vs legacy tax regime) depending upon what is tax advantageous for them.

The government has kept the legacy tax regime largely untouched. Tax rates and quantum of common exemptions and deductions claimed by a taxpayer have remained largely constant. For example, the maximum deduction (₹1.5 lakh) available under Section 80C of the Income-tax Act, 1961 (Act), which includes home loan principal repayments, provident fund and public provident fund contribution, life insurance premium etc. has remain unaltered since 2014. Similarly, deduction available for home loan interest on a self-occupied house property was last increased to ₹2 lakh in 2014 and has not been increased since then.

During 2014-24, cumulative consumer inflation as measured by CPI has been in excess of 60 per cent. If CPI was taken as the measure of inflation, then the deduction under Section 80C of ₹1.5 lakh in 2014 is equivalent to ₹2.4 lakh in 2024 prices. Similarly, ₹2-lakh deduction available for home loan on a self occupied property is equivalent to ₹3.2 lakh in 2024 prices. This implies that the real value of these exemptions has been coming down.

Recalibration impact

On the other hand, the government has been promoting new tax regime since its introduction due to reduced compliance burden both on the taxpayers and tax authorities. Tax slabs and tax rates under the new tax regime have been rationalised to make it more attractive. In the final Budget of 2024, the tax brackets were further rejigged to provide extra tax benefit of up to ₹17,500 (excluding surcharge and cess) to taxpayers. This has been achieved by allowing higher amount of standard deduction from salary and reduction in tax rates under the new tax regime.

However, the burning question, which remains to be answered, is whether recalibration of the new tax regime and lowering of tax rates is beating the annual inflation and whether it is having any real positive impact in the spending capacity and savings for the lower- and middle-income category of taxpayers.

Currently, India does not follow any mechanism which links tax slabs and the amount of exemptions and deductions with the rate of inflation. For this, the Indian government may take cues from developed economies where the tax slabs are recalibrated by factoring in annual inflation. The US, for example, adjusts the income brackets in tandem with the annual inflation rate. Similarly, countries such as Germany, Finland, Sweden and Norway factor in the cost-of-living index to adjust the income slabs every year. Most recently, Austria has adopted an automatic inflation adjustment mechanism to rationalise the income slabs every year.

Thus, the government could use the annual inflation rate to adjust tax slabs, exemptions and deductions. This would help maintain the real income of tax payers, preventing inflation from eroding their post-tax purchasing power. By aligning taxable income with inflation, people could retain their standard of living and have more income to spend.

The authors are Partners at EY India; Akshay Sharma, Director - Tax (EY India), has also contributed to the article