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Inflation and Taxes

Remember when our parents used to complain about the rising price of various commodities every day? Well, we might not have understood them then, but now that we have to pay our own bills, we all surely feel the pinch of inflation. 

To put it very simply, inflation means a rise in the price of goods and services and consequently, it also means a fall in the purchasing power of money. While inflation is generally looked down upon, some economists opine that a low level of inflation at around 2% can be beneficial as it can keep the economy away from stagnation.

However, what we are witnessing today is a quite high level of inflation accompanied by slow growth. This means the price of goods and services is rising much faster than people’s income thereby eroding the standard of living of the common man.

The war between Russia and Ukraine has caused global supply chain disruptions, pushing up the prices of Crude oil and other items. This has caused leaders all around the world to take notice and come up with solutions to fight inflation.

India for example has unveiled inflation-fighting fiscal measures worth almost INR 2 lakh crore. These measures would include lowering fuel taxes, import levies and increasing subsidies on cooking gas and fertilizers.

Impact of Inflation on Income Tax

While a lot is talked about how inflation affects finances, the standard of living and spending power not much is discussed how inflation affects taxes.
That is mainly because there is no simple, straight answer to this. Inflation impacts taxes both from the perspective of the taxpayer as well as the government that is collecting and utilising the taxes. When it comes to income taxes, a high rate of inflation usually increases the tax burden on the taxpayers if taxes are not inflation adjusted. Let us understand it by means of a simple example

  • Suppose you earn INR 5 lacs a year in 2019 and hence fall into the 5% tax bracket
  • In 2020 you get a raise of 8% and your income becomes INR 5.4 LPA

    Now, if we hypothetically consider an inflation rate of 8%, it would mean that your real income has not increased at all. Your INR 5.4 lakhs today has about the same purchasing power as your INR 5 lakhs in 2019
  • However, owing to the nominal increase in your income, i.e from INR 5 lakhs to INR 5.4 lakhs you are now in the 10% tax bracket

    So although your real income did not increase owing to inflation, your tax liability did. That hurts, doesn’t it!

Capital gain is another type of income that is severely affected by a higher rate of inflation.  Consequently, capital gain taxes can significantly reduce the return on investment if they are not adjusted for inflation, Let’s consider another hypothetical case to demonstrate it

  • Let’s say that you purchased INR 1,00,000 worth of listed shares in March 2018 and sold them for INR 2,50,000 in March 2022
  • So, on paper, your long term capital gain is worth INR (2,50,000- 1,00,00) = INR 1,50,000
  • Your LTCG tax liability will be 10% of INR 50,000 (considering the INR 1 lakh exemption) which is INR 5000
    Now let us factor in inflation.
  • Considering an average inflation rate of 5% each year, the cumulative inflation rate over the period of investment i.e 4 years would be 20%
  • Therefore, the real gain from your investment is not INR 1,50,000 rather it will be 80% of INR 1,50,000 because 20% of your gain has been eroded by inflation
  • Consequently, your real gain will be 80% of INR 1,50,000 which is INR 1,20,000
  • So, your tax liability on your real gain should have been 10% of INR 20,000 (considering the INR 1,00,000 exemption limit) which is INR 2000

    However owing to your gain of INR 1,50,000 on paper, your tax liability will be more if there is an absence of inflation indexing of taxes.

What is Inflation Indexing of Taxes?

We mentioned how the absence of Inflation Indexing can increase the tax burden on taxpayers.

But what is inflation indexing?

Inflation indexing is cost-of-living adjustments built into tax provisions to keep pace with inflation. Without inflation indexation, a greater share of a taxpayer’s income can be taxed even if their real income has not increased to that rate. The two aforementioned examples showed how your tax burden can increase owing to an increase in your nominal income, although your real income might not have increased that much.

Enough with the jargon, let’s break down inflation indexing with an example closer home.

In India, the benefit of inflation indexing is allowed on Long Term Capital Gains (except on listed equity shares & mutual funds). The logic behind providing this benefit on Long Term Capital Gains is that Long Term Capital Assets like buildings, gold, and land are usually bought and held for a long time before they are sold. Now they are recorded at cost price and their value can’t be reassessed. So, once the asset is sold, the cumulative effect of inflation on the profit will be significant and the real income will be much less compared to what will be on paper.

Let’s break it down further with an example. 

  • Suppose you buy a house in 2010 worth INR 10,00,000 and you sell it in 2020 for INR 20,00,000
  • So you made a gain of INR (20,00,000- 10,00,000)= INR 10,00,000
  • Your tax liability will be 20% of INR 10,00,000 which is INR 2,00,000
  • However, considering an average of 4% inflation throughout these 10 years, your real gain will be simply 60% of INR 10,00,000 i,e, INR 6,00,000 since the rest 40% has been eroded by inflation.
  • But since your nominal gain is INR 10,00,000 you will have to pay 20% taxes on it. Now that is steep!

To overcome this very situation, the Indian government provides the benefit of inflation indexing. Here, the cost price of an asset (in case of long term capital gain) is adjusted as per inflation and while tax computation the inflation-adjusted price is taken as the cost price instead of the original cost price.

Cost Inflation Index

Every year, the CBDT announces the Cost of Inflation Index (CII) which is used to calculate the inflation-adjusted cost price of an asset.
And as we mentioned the inflation-adjusted price is then used to arrive at long-term capital gains or long-term losses.

2001-02 is taken as the base year and the CII for that year is 100. From that year onwards, the CII increases with the rate of inflation.

The following table shows the CII over the years

Financial YearCost Inflation Index (CII)
2001-02 (Base Year)100

Now, how to use this index to calculate your inflation adjusted cost price i.e. indexed cost of acquisition? The formula is

CII of the year of sale/CII for the year of purchase * Actual cost price

So, let us use this formula to understand the inflation-adjusted cost price of our previous example:

  • According to our previous example, the Cost price of the house in 2010 was INR 10,00,000 and the selling price in 2020 was INR 20,00,000
  • By using the formula the inflation-adjusted cost price will be:
    CII of the year of sale (2020)i.e. 301/ /CII for the year of purchase (2010) i.e 167 * Actual cost price. i.e INR 10,00,000
  • 301/167* INR 10,00,000 = INR 18,00,000
  • So instead of INR 10,00,000, now your inflation adjusted cost price becomes INR 18,00,000
  • Your LTCG tax liability will be 20% of INR (20,00,000-18,00,000)= INR 40,000

This is in tune with your real income, income that is adjusted to inflation and not just your nominal income.

Not just in India, many countries opt for inflation indexing of taxes to preserve the spending power of the people.

So how has inflation affected you the most? Share your thoughts with us.

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