Reviewed by Sep 30, 2020| Updated on
Tax indexing refers to the method of adjusting tax rates for incremental tax outgo due to an increase in inflation. Inflation results in taxation of income in the higher tax bracket. This results in an increase in the overall tax liability without any real increase in purchasing power of the taxpayer. Tax indexing helps in eliminating the potential tax outgo due to inflation.
In general, the income tax laws do not respond immediately to change in economic conditions resulting in a change in purchasing power. Tax indexing ties the incomes and tax rates to an index to maintain the taxpayer’s purchasing power during the period of inflation.
Due to inflation adjustment, a taxpayer’s income may move to a higher tax bracket resulting in higher taxes. The overall increment may be negative with no real increase in purchasing power.
Here is an example to understand who is eligible for tax indexing:
A taxpayer earning an annual salary of Rs 9.8 lakh would be in the Rs 5 to 10 lakh tax bracket of 20% in India. The taxpayer’s salary would be revised by 8% to accommodate inflation and hike in compensation. This would result in the taxpayer moving to the Rs 10 lakh and above tax bracket. The taxpayer would end up paying more taxes than the increase in the real disposable income.
In a case of application of the concept of tax indexing, an inflation rate adjustment is made to the cut off for the next tax bracket. In the above example, an inflation adjustment factor of 5% would make the income of Rs 10.29 lakh taxable in the 20% bracket. Thus, inflation adjustment through tax indexing ensures taxpayers are on par in a year-on-year basis.