What should we tax: Nominal or Real Income?

The base of income tax all over the world is nominal income that you earned in the previous financial year. Although, it is plain and simple to collect tax on nominal income yet it has serious limitations. Suppose your monetary (nominal) income remains same but you witnessed inflation rising from 5% to 10%. Three types of response can happen. One, your income may raise fully to compensate the rise in inflation (this is your real income remains fixed); two, you may see partial compensation of monetary income; finally, you may see no upward adjustment of your income. In this case you suffered income erosion due to high inflation. Further, consider when inflation is high and variable and uncertain nobody can perfectly predict the future income. That means you are bound see your income deprecating due to high inflation. The pain does not end here!

But does the income tax recognize the pain that you suffered from real income erosion due to high inflation? Sorry, no. It does not care what your real income is. It is interested to see what your monetary income is. It adds salt to your wounded area.

So, you see inflation leads to a double-loss of your real income. First, inflation does not bring an upward revision of your income. Second, you are taxed on your nominal income. A simple example is given to help you better understand this point. Suppose your income is 2 lakhs per annum. Tax exemption limit is Rs 1 lakh. That means taxable income is Rs 1 lakhs. Now bring inflation into discussion. Say, inflation is 10%. That is WPI has moved from 100 to 110. But your nominal income has not increased. So you suffered your first loss. You receive the second loss when you pay income tax. Tax rate is 10%. That means you have to pay Rs 10,000 to the tax department as your income tax. Real income is nominal income divided by inflation rate. Real income is (Rs 100000/110)*100 = Rs 90909. Income tax is Rs 90909*0.1 = 9091. So you save: Rs 10000 (which you have to pay when taxation is based on your nominal income) - Rs 90909 (which you have to pay when taxation is based on your real income) = Rs 909. This says if you are taxed on nominal income then you are paying Rs 909 more to income tax department. If your income remains same and inflation continues to rise at 10% per annum, in 5 years you can save: Rs 909*5 = Rs 4545. Not a small sum that you can choose to neglect!

So, i think is better to tax income not on the basis of what your monetary income is, rather what your real income is. The benefits are huge. Government has no other option than to rein in inflation. As a result, citizens will less bother about inflation. Governments have paid huge price for not controlling inflation. The recently concluded general election provided fresh evidence to it.