India's Tax Base Problem Is Not Just About the Rich Not Paying Enough

Finance ministry officials have taken visible satisfaction in recent years pointing to the improving ratio between India's direct and indirect tax collections, with direct taxes, primarily income tax and corporate tax, now exceeding indirect tax collections including GST, customs and excise for the first time in roughly two decades on some measures. This is generally treated as good news by public finance economists, since direct taxes are broadly progressive, falling more heavily on those with greater ability to pay, while indirect taxes like GST are regressive in their incidence, taking a larger share of income from poorer households who spend a higher proportion of what they earn on consumption subject to the same tax rate as wealthier households.

The improvement is real and worth acknowledging: corporate tax collections have grown as corporate profitability recovered post-pandemic, and personal income tax collections have grown even faster, partly reflecting genuine income growth among salaried and self-employed taxpayers, partly reflecting improved compliance enabled by pre-filled returns, expanded TDS coverage, and data-matching between income tax returns, GST filings and bank transaction reporting that has made evasion considerably riskier than it once was.

The base is still remarkably narrow

The improving ratio, however, sits alongside a much less celebrated fact: India's income tax base remains extraordinarily narrow relative to its population and workforce. Fewer than 8 crore individuals file income tax returns in a country of over 140 crore people and a workforce exceeding 55 crore, and a considerably smaller number, generally estimated around 2 to 3 crore, actually pay any income tax after the basic exemption threshold and the various deductions and rebates available, including the significant rebate under Section 87A that effectively zeroes out tax liability for individuals earning up to a threshold that has been progressively raised, most recently to 12 lakh rupees under the new tax regime announced in the 2025 budget.

This narrowness is not simply a matter of widespread evasion, though evasion remains a genuine problem, particularly among high-income professionals and small business owners who under-report income relative to salaried employees whose tax is deducted at source before they ever see the money. It substantially reflects the reality that most of India's workforce earns too little to owe income tax under any reasonable threshold, given that a large majority work in agriculture, which is constitutionally and as a matter of long-standing political consensus exempt from income tax altogether, or in low-wage informal employment falling well below the exemption limit even before considering deductions.

Agricultural income and the exemption nobody touches

The agricultural income tax exemption is one of the most politically untouchable features of the entire Indian tax system, defended across every political party, and it is defensible for the large majority of farmers who genuinely earn modest, often precarious incomes from cultivation. But it has also long been recognised, including by government-appointed committees going back decades, as a loophole exploited by a small number of wealthy individuals who route non-agricultural income through agricultural income declarations to escape taxation, a form of leakage that periodic proposals to at least require disclosure and cross-verification of large claimed agricultural incomes have never managed to overcome politically, given how instantly any suggestion of taxing agricultural income, however narrowly targeted at abuse, gets characterised as an attack on farmers broadly.

Corporate tax concentration and the informal sector mirror

A similar concentration pattern exists on the corporate side. A relatively small number of large corporations account for a disproportionate share of corporate tax collections, while millions of registered but small companies and limited liability partnerships contribute comparatively little, again reflecting genuine differences in profitability and scale rather than a design flaw exactly, but reinforcing the broader pattern that India's formal tax base, on both individual and corporate sides, is a narrow pyramid resting atop a very large informal economy that generates significant output and employment but contributes minimally to direct tax revenue.

This is where the direct-to-indirect ratio conversation, however encouraging its recent trend, can be somewhat misleading if taken as evidence that India's fiscal capacity problem is being solved. GST, precisely because it captures transactions throughout the value chain and does not depend on the buyer or seller being individually registered for income tax, has become the mechanism through which the informal economy's consumption, if not its income, gets taxed at all. A narrow income tax base combined with a broader-based GST is, in some sense, India's practical accommodation to the reality that formal income tax administration cannot reach the majority of economic activity, even as it remains a regressive way to fund public expenditure relative to a genuinely broader income tax net.

What broadening the base would actually require

Widening India's direct tax base sustainably requires less a matter of raising rates, which India's government has if anything been lowering in recent years, including the 2025 budget's substantial increase in the no-tax threshold, and more a matter of raising the incomes and formalising the employment of the tens of crores of Indians who currently earn too little or work too informally to fall within reach of the income tax system regardless of its design. This links India's tax base question directly to its broader development challenges: manufacturing job creation, agricultural productivity growth that would let fewer people extract more income from farming, and the formalisation of services and retail employment that GST's data trail has begun but far from completed.

A structural problem, not a rate problem

The temptation in tax policy discourse is to frame base-narrowness as a problem of insufficient enforcement or excessively generous exemptions, both of which are real but secondary factors. The primary constraint is that a very large share of India's population simply does not yet earn enough, in the formal, documented sense the income tax system requires, to be taxed on income at all. The improving direct-to-indirect ratio is a genuinely encouraging trend, reflecting real gains in compliance and genuine income growth among those already inside the formal economy. But it should not be mistaken for evidence that India's fiscal capacity constraint, rooted in the depth of formal economic participation across the country, has been meaningfully resolved. That resolution, if it comes, will arrive through the slower work of economic development and formalisation, not through any clever redesign of tax rates or exemption thresholds alone.