The Game Unmasked: Tax Exemption in Indian Agriculture

-Anaya Nandish Shah and Pulkit Rajmohan Agarwal

Introduction

Section 10 of the Income Tax Act, 1961 (“the Act”) enlists the exemptions that would be granted to the assesses of all the income groups while computing their income tax. Agricultural income falls within the ambit of exemptions enumerated in the aforementioned section. The scope of income within the agricultural sector is wide-ranging as it encompasses numerous activities such as rent and other incomes received from agricultural lands and processing of agricultural produce, income received from saplings and seedlings grown in nurseries, hydroponic activities etc, and the Act provides a blanket exemption for such activities. This means that regardless of the amount of income earned from these agricultural undertakings, whether by individuals or large corporations, no income tax will be imposed on them. This blog attempts to analyse the interplay of law and economic ramifications of introducing taxes on agricultural income, through the game theory model.

The present dilemma

Several reports of the committees set up by the Government, such as the Report of the Task Force on Direct Taxes (Kelkar Committee),White Paper on Black Money  highlight the negative implications of non-taxation of the agricultural income citing reasons such as tax evasion and unaccountability.  Another Committee, Tax Administration Reforms Committee highlighted that the affluent farmers surpass the earnings of salaried employees and yet they conveniently evade taxation. To counter this, they proposed to introduce taxation brackets upon the income instead of providing blanket exemption, thereby bringing the affluent within the purview of taxation. .  Reiterating these reports, Bibek Debroy, the Chairman of The Economics Advisory Council to the Prime Minister of India, stated political clout as one of the major reasons for non-taxation.

Such an exemption primarily impacts two key entities: the Government, and the beneficiaries of the exemption such as farmers and corporates engaged in agricultural activities. Subsequently, a policy of providing a blanket exemption sends signals to the market. This not only benefits the intended beneficiaries but also all those individuals and corporate bodies that shield their income under the garb of the said exemption

An economical perspective

Remittance of Income Tax can be seen as a transaction between the tax authority and the taxpayers (herein the farmers and corporations). Persons, both natural and legal, who are currently indulged in agricultural activities are given the benefit of complete exemption from taxes on the income arising out of such activities. However, this market exchange is affected by externalities of tax evasion and money laundering. These externalities or non-market exchanges have directly affected the revenue department, as the outcome is a substantial monetary loss, which could have been utilised for the benefit of the economy. As per the CAG Report, out of the permitted exemption claims that were reviewed, many of them lacked verification of supporting documents or any documentary proof at all. This outcome of non-market exchange remains unaccounted for, in the absence of the laws and the liability system to internalise it.

To counter the issue of tax evasion, either the tax authority can ensure stricter norms and enforcement through efficient audits, assessments and if required litigations otherwise they can make agriculture income taxable thus curbing money laundering. Individuals and corporates often use the exemption as a leeway to divulge their non-agricultural income as agricultural income thereby evading taxes. In the situation of non-taxation of agricultural income, it would be prohibitively expensive for the government to verify and assess each and every claim of exemption. On the other hand, farmers and corporations would incur low costs in evading and laundering money. This leads us to consider the option of taxation of agricultural income, which in this case is a low-cost mechanism for the government as compared to other possibilities such as strengthening enforcement mechanisms to detect laundering.

Application of game theory

The game theory suggests that all the rational players in a market pursue profit-maximising behaviour, however, everything that is individually rational is not always socially rational. Hence, the strategy of each player depends upon how the other players in the market would react to that move i.e., the outcome for one person depends upon the choice of another person. In the current scenario, the players are (i) the farmers, corporations, i.e., the beneficiaries of the exemption and (ii) the government. In the present game wherein, the law provides for exemption of agricultural income, the government is losing upon a lot of taxable revenue, whereas the farmers and corporations are incurring low costs owing to exemptions. Along with these beneficiaries, a few individuals use this as a leeway to launder money. If the government starts taxing agricultural income, the government would be better off as they would be able to tap into a lot of revenue, simultaneously the issue pertaining to money laundering would get resolved. Whereas, the farmers and corporations would be at a loss as their costs would be increased owing to the taxes.

Let us consider an example wherein the agricultural income of the farmer is Rs 100. And if the government starts levying taxes, then the farmer would have to shell out Rs 20. In this case, the joint value remains at Rs 100. But in a situation where there is no scheme of taxation, even then the joint value remains at 100, however, government loses its revenue to the tune of Rs 20 due to the tax exemption, as explained in the Table shown below

Table 1 initially discusses the pre – evasion scenario followed by accounting for the externality and its impact on the outcome.

Table 2 through the proposed solution of implementation of taxation, explains the output and surplus created, further leading towards a co-operative outcome.

However, the  aforementioned scenario is an idealistic situation wherein the externalities have not been accounted for. Practically, if we account for externalities such as tax evasions, there arises  a situation wherein the government had already foregone Rs. 20 due to non-taxation additionally, it would now incur losses equivalent to Rs.20 because such an exemption provides a leeway for people to launder money and evade taxes. The output of the beneficiary now falls from 100 to 90 and the Joint Value now falls from 100 to 70.

Such an outcome is not efficient as both the parties would be at a loss and their joint value would reduce. However, an efficient tax can be imposed by the government, to curb tax evasion, but simultaneously the tax scheme should be such that the outcome is not below the threat values of the parties. Herein, say a lower tax is introduced, such that the farmers with incomes exceeding a specific threshold have to pay the taxes. Through this, the government would gain 10 as upfront from the revenue, simultaneously mitigating the risk of losing 20 to tax evasion. However, such a step is unfavourable to the beneficiaries of the scheme as they would have to shell out taxes from their disposable incomes. To counter this, the government can equally share their surplus [herein, 30] so created out of taxation, with the beneficiaries by providing them with additional grants, subsidies out of the revenue  earned. The outcome of the cooperation, for beneficiaries, would be 105, which would not only surpass the threat value but also the position prior to taxation.  The government loses 5, nonetheless, such expenditure would directly contribute towards the development of the agricultural sector rather than losing it to the people who dodge taxes. This taxation, would remove the blanket exemption and bring the incomes under tax scrutiny leading to a more transparent economy. The bargains in the game theory would lead to a situation wherein the joint value of the government and the taxpayers would be maximised thus resulting in a change in the dominant strategy of tax evasion and money laundering.

Conclusion

As proposed by the game theory model, it would be efficient for the government to tax agricultural income. It is pertinent to note that even after the taxation of agricultural income, majority of the small and marginal agricultural households would still be able to avail other benefits such as the base limit and the rebate under section 87A of the Act. Conversely, only those farmers and corporations surpassing the non-taxable levels of income, would be subject to taxes. Therefore, if a proper mechanism is in place, it would also serve as a disincentive for evasion and laundering.

However, in India, the agricultural sector is a politically sensitive arena, and past policy decisions concerning the sector have resulted in significant outcry and backlash. This makes the issue of taxing agricultural income akin to opening a Pandora’s Box, as it has the potential to impact the overall political stability of the nation.  And this has been one of the main reasons why political leaders have not been and are not inclined to interfere much in this area. Political clout can be seen as one of the major hindrances when it comes to implementation. When liabilities are parcelled by governments in this way it allows tax evaders to escape their obligations, and this can have significant economic consequences. The delay in taxation has already caused significant revenue loss, any further delay would lead to more disruptions. Instead, the government should disentangle itself from the political sway, take prompt action, adhere to the spirit of taxation on progressive lines and undertake necessary measures.

Anaya Nandish Shah and Pulkit Rajmohan Agarwal  are 3rd Year students of law at Gujarat National Law University