The Indian middle class is in a financial squeeze. Overwhelmed with increasing tax rates and low disposable incomes, its consumption patterns seem to be slowing — a troubling trend for an economy where domestic consumption demand accounts for 60% of gross domestic product (GDP).
The Indian government has faced severe criticism for its inability to reduce this burden, particularly as GDP dipped to 5.4% in Q3, a significant slippage from 6.7% in Q2, 7.8% in Q1 and 8.6% in Q4 2023. But can the Indian middle class’s tax burden be reduced without compromising fiscal stability?
Many experts, including Thomas Piketty, have advocated for higher taxes for the richest 1% to ease the strain on the Indian middle class. While this proposal has its merits, two key issues emerge.
First is the longstanding conundrum over whether higher taxes on the rich might lead to reduced capital formation, potentially affecting job creation and long-term economic growth.
Second, even with increased taxation on high-income groups, the scope for significantly reducing taxes on the middle class remains limited given the fiscal constraints and the government’s reliance on transfer payments to support vulnerable populations.
Theoretically, higher personal income taxes or wealth taxes for rich individuals should negatively affect financial markets or businesses directly, as their willingness to invest in these areas should decline.
However, extensive economic research, including studies by Emmanuel Saez and others, finds little evidence that high-income earners were discouraged from investing due to increased taxes.
For instance, despite top income tax rates dwindling from 70% in 1965 to under mid-30% in 2024, drastic changes in growth rates have not been noted in the US. Over the past decades, economic growth, when measured on a ten-year moving average, has consistently hovered between 3% and 4% since 1974.
This is contradictory to the theory in the sense that lower taxes are supposed to spur investments. It is thus logical to surmise that higher tax rates won’t act as disincentives, making the wealthy shy away from innovative investments. The real driver of investment remains strong and consistent demand, particularly from the middle class, whose spending fuels growth across sectors.
But does the aforementioned behavior hold for India? The answer is yes judging by the impact corporate tax rates have had on investments. Corporate rates in India were cut in September 2019 from 30% to 22% for existing companies and from 25% to 15% for new companies.
Despite a loss of tax revenue of around 1 lakh crore (US$13.33 billion at prevailing rates) in 2020-21 for the government, the net benefit from the cut in terms of increased employment and investment was minimal. Rather, tax cuts increased the profits on existing capital, with nearly no benefits for wage-earners.
As per the Periodic Labor Force Survey (PLFS), the regular wage employment across rural and urban India has fallen from 22.8% in 2017-18 to 21.7% in 2023-24. The real compound annual growth rate (CAGR) for real wages for rural workers showed a slight decline of -0.18% while urban workers experienced a marginal increase of 0.25% over the same period.
In contrast, pay growth for top executives in Indian firms has significantly outpaced that of the average salaried worker, with CEO-to-median pay ratios in some firms increasing by as much as four times between 2020 and 2024.
This also mirrors trends in several economies, including the United States, where the CEO-to-worker pay ratio soared from about 20:1 in 1965 to 354:1 in 2012, even as wages for both skilled and unskilled workers declined.
As the evidence highlights, a higher tax on India’s wealthiest entities may not necessarily harm capital formation. However, research shows that higher taxes often lead to increased tax evasion rather than greater compliance.
This becomes particularly relevant when considering India’s tax structure: in FY 2023-24, only 6.68% of the population filed an income tax return, and nearly 49 million individuals reported zero taxable income out of 80.9 million filers.
Moreover, 6,084 cases of tax evasion involving 2.01 trillion rupees ($24.2 billion) in GST were recorded during the same time. The sheer magnitude of such evasion shifts the burden of maintaining fiscal stability disproportionately onto the middle class—an inequity that could have been mitigated with better compliance rates.
But are higher tax rates the sole factor driving increased tax evasion? Data suggests otherwise. Even with declining tax rates—both personal income and corporate taxes—tax evasion has continued to rise. For instance, despite a corporate tax cut in India in 2019, GST evasion seems to have surged fivefold from 2017-18 to 2021-22.
This indicates that tax evasion may stem more from individual tendencies than tax levels alone. To address this, India must focus on reforming its taxation system to make evasion significantly more costly rather than relying solely on lower rates to encourage compliance.
This brings us to the other crucial issue, that is, even if the Indian government is able to collect higher taxes from the wealthiest entities, it may not be enough to substantially reduce the tax burden on the middle class.
For example, if a wealth tax of 2% is imposed on Indians with assets above 100 million rupees, it would only raise around 1% of GDP. This suggests that the middle class would still bear the bulk of the tax burden.
In countries with high top-income tax rates and wealth taxes, like several European nations, average earners typically contribute the majority of government revenues.
Similarly, in India, food subsidy programs, including initiatives like the Pradhan Mantri Garib Kalyan Anna Yojana (PMGKAY), account for a significant portion of government spending, contributing roughly 1% of GDP.
As such, tax reform like a 2% wealth tax wouldn’t be sufficient to decrease the middle-class burden significantly, but would only provide marginal relief.
The solution lies not just in increasing tax rates on the wealthy but in reforming India’s tax system to boost compliance and curb evasion. While measures such as simplified e-filing options have contributed to a moderate increase in government revenue, tax evasion continues to rise.
To address this, India needs to implement stricter penalties and enhance its ability to detect and prevent evasion. By expanding the tax base and improving compliance, the government could ultimately reduce tax rates for the middle class, providing more meaningful relief in the future.
Another promising strategy to improve tax compliance is leveraging informal mechanisms of enforcement, such as societal norms. Behavioral interventions, commonly referred to as “nudges”, have been shown by Saulitis and Chapkovski (2024) to be effective in encouraging individuals to pay taxes and reduce tax evasion.
By subtly guiding people towards desired behaviors, these interventions work to reshape the social contract around tax compliance. Over time, as societal attitudes shift, a new norm can emerge where paying taxes is seen as a civic duty and a sign of social responsibility, rather than an obligation to be avoided.
In India, much of the tax evasion may be rooted in a negative perception of taxes, which has historical and cultural roots. During the colonial era, the British imposed exploitative and heavy taxes, which bred distrust and resentment toward the tax system.
These feelings have persisted, contributing to the ongoing reluctance to comply with tax obligations. Over time, the tax system became associated with oppression and exploitation rather than fairness and civic duty.
While India grapples with the challenge of alleviating the tax burden on its middle class, a combination of stricter penalties, improved detection of tax evasion and the incorporation of behavioral insights—along with the strategic leveraging of societal norms—could offer a pathway toward sustainable fiscal stability.
Attrishu Bordoloi is a development economist with an MPhil from the University of Cambridge. He currently works as an economic policy analyst at the Centre for Effective Governance of Indian States and is associated as an economic consultant with the World Bank and Futureworks Consulting.