Income Tax basics: What is income tax and why do we have to pay it

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What is income tax? Why do we pay taxes? Should we pay income-tax?

Let me try and answer some such questions.

What is income tax?

A straightforward interpretation would be that it is a tax on the income. So to understand income tax, we need to understand these two words – tax and income.

What is tax and what is income?

A tax is a levy – it is a statutory, mandatory payment made to the government. And, what is income tax? When the amount to be paid is a percentage of the income, it is called income tax.

When we pay to the government a percentage of the value of goods manufactured, it is called ‘excise duty’. When it is a percentage of goods entering into the country, it is called ‘customs duty’. When it is a percentage of the value of goods entering a city – ‘octroi’. When it is a percentage of the value of goods sold – VAT. Percentage of the value of services rendered – ‘service tax’.

We keep paying the government in a variety of ways. Yet another way in which we pay is when it is a percentage of our income. Then the tax is called income tax. The critical word to be understood is ‘income’. Unless you know what is income you will not be able to work out the income tax payable

So, what is income? Income from the point of view of Income Tax. The amount which needs to be declared in the Income Tax Return.

People have a number of misconceptions when it comes to defining income.

One response is that income is everything that comes in – all the receipts of money. But this is too broad a definition. Many receipts do not constitute income. For example, a loan taken from a bank brings money in but is obviously not ‘income’. Also inheritances are not considered ‘income’. Nor are gifts, under certain circumstances.

Another reaction is that income refers to earnings. But unearned receipts, such as winnings from lottery or lucky draws, are also income subject to income tax.

So ‘income’ is something broader than mere earnings and not as broad as to cover all receipts.

Yet another misconception is that legal earnings are ‘income’ and illegally obtained money is not.

The truth is that ‘income’ for the purposes of income tax covers almost all the money coming in, barring a few specific exceptions like loans, and gifts (in some cases) and inheritances. It does not matter whether it is earned or unearned, legal or illegal, received or accrued.

Should we pay income-tax?

It doesn’t matter how much it may hurt people to pay taxes, whenever I ask this question, invariably the answer is ‘of course, we should pay.’

What really hurts people is not so much the paying as the misuse of the money paid, or when it goes to line the pockets of unscrupulous and corrupt government officials. If people were sure that the taxes paid will actually be used for the purpose for which they were collected, more people would pay happily.

Why do we pay taxes?

Taxes are obviously paid so that governments can raise the resources to pay for the various facilities provided for us, but which none of us can provide for ourselves individually.1

Even if I don’t go into complicated theories of taxation and take some blatant examples of services and amenities that the government provides – roads, street lighting, police – all of which are of a nature that is neither possible nor affordable for citizens of a country to obtain on their own. I mean, if the government asks each individual to build a road for say a hundred metres outside their respective houses, a majority of us will not be able to afford it. But how many miles and miles of roads do we use? We use postal services. We use the railways (which so far in India is in government hands). The police is there to protect us. Without the army guarding our borders we probably could be slaves to some marauding and ambitious rogue nation.

So the logic of income tax (as other taxes) is – that all of us use the facilities and hence all of us must pay.

The problem of income tax is – all of us use the facilities, but all of us don’t pay. Not only that all of us don’t pay, but all of us can’t pay.

And why can’t all of us pay? This is because a large percentage of our population lives below what is known as the Poverty Line.