Often times we come across so-called people telling how usurious taxes are. If you ask them how much percent of Income is given as taxes either they scoot or give generic 30% as the answer. This oftentimes gives doubt on the expertise of that person regarding taxes. Effective Tax Rate is the most important figure one should know. Especially, If one needs to pass on any sort of judgment or help regarding taxes, you cannot escape from this.

The formula for the effective tax rate is

 $Effective Tax Rate= \frac{Total Tax Payable}{Total Income}$

Though its simple formula, it hides a great deal of complexity underneath it. The Total Tax Payable itself can throw out someone as its a calculated figure with some accounting wizardry behind it. The Total Income figure is actually a heavyweight in taxation circles. The Tax Law is about this figure itself.

Effective Tax Rate: What it is?

Effective Tax Rate is the percentage of Tax Liability to Total Income.

Me

As explained above, the ETR is the percentage of Tax Liability to Total Income. Most noteworthy, The tax department uses this in setting up rates. Therefore, the Slab System used everywhere is just a contraption around ETR. The slab system is used so as to help the person whose income is marginally higher than the slab. For Example: If One has income 5,00,100 as his income, the higher slab is applicable only on 100, not on 5,00,000. Similarly, there is a system of marginal relief for surcharge based tax slabs too. The ETR looks discriminatory if seen as is, hence the slab system is used cloak it.

The slabs are applicable to Net Taxable Income. Calculating this NTI is governed by the Income Tax Act, 1961. The Direct Tax Code is actually a plan to replace this old act. This act has grown complex after lots of amendments done over time. The main complexity of tax law is in the system of Exemptions, Deductions & Rebates. PS: Those 3 are different things. Tax laws are complex for everyone, because of this itself. The next section will explain it.

Exemptions, Deductions & Rebates: The complexity

The Exemptions, Deductions & Rebates act at various levels of taxation hierarchy. Also, The EDR is used heavily in the politics of taxes. For Example Tax rebates announced in the previous budget, resulted in social media filling up tax calculations. Once you are able to understand EDR, tax politics starts unwinding. Without much ado, let us dive first into Exemptions.

Exemptions

The exemptions are provided for incomes. In tax lingo, exemptions are those incomes, which are not part of total income. Section 10 of the income tax act deals with these. The ETR formula takes only total income, hence this is not a part of ETR calculation. But there are some complex shenanigans with them in ITR. One such is with Agri Incomes. Since EI’s are not part of total income, ignore it. Lets now move over to deductions.

Deductions

Deductions are provided for certain category cash outflows. The ELSS investments, PF, Insurance are all forms of cash outflows. But cash outflows have different flavors. Revenue Expenses, Investments, and Capital Expenses are 3 broad categories of Cash Outflows. Loan Interest is Expense, whereas Insurance is a form of CapEx. ELSS is Investment. The ‘Net Taxable Income’ is ‘Total Income’ minus ‘Deductions’. The taxes are based on NTI, not TI. Lets now move over to the last component of rebates.

Rebates

The Tax Liability is calculated from Net Taxable Income. Then the rebate is deducted from this. Since rebate is based on tax liability, it is useless to map it back to total income. This is also a favorite tool for FMs too. After deducting rebate we get Total Tax Payable, ETR uses this figure.

Total Tax Payable minus the TDS gives Net Tax Payable/Refundable. And most importantly, your Tax Return contains all these things.

Conclusion
  • Taxable income is nothing but an unexempted income.
  • Incomes like Cap Gains are taxed at special rates, hence not part of NTI.
  • Slab system is applicable only to NTI, not on special rate items.
  • These things are all basics of taxation but also the playground of politics.
  • DTC is a complete rethink of the IT Act, hence EDR structure will see a much-needed overhaul.
  • Slab System is the most important cloaking system available to mankind, hence it will stay even in DTC.
  • Govts love direct taxes because of its predictable nature compared to indirect ones. But this hardest one to administer too.
  • Taxes are the cost of civilization. they fund everything around you including the value of money you hold, a valuation to your land/investments. So don’t go overboard in hatred of it.
  • Taxes are income to govt like sales are to companies, & salaries are to you. Controlling these by outside parties ( i.e govt controlling salaries & sales – communism, people controlling sales & taxes – anarchy, companies controlling salaries & taxes – crony capitalism) has always been disastrous.