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How Income Tax Works
June 06 , 2012

An old saying goes; 'Only two things are certain - death and taxes; and one is not sure about the former'. We all hate income tax, but we all have to pay it nevertheless. Even if we don't manage to pay it with a smile, it is important we know its basics - for one, it could reduce our tax outflow. Secondly, it is actually pretty simple, despite the attempts of the Government to complicate it through endless exemptions and caveat and couch it in legalese.

In this article, we look at Income Tax, which is a Direct Tax and how income tax works. That means, it is paid on an individual or company's income or profits. This is as against an Indirect Tax like Excise Duty or Sales Tax that is paid during any transaction. We will also limit ourselves here to salaried persons. Two features will repeatedly haunt us as we go through Income Tax:

1. Government favours the poor in structuring income tax. So the poorest pay no tax, and tax rates increase as income increases.

2. Government also uses income tax to favour certain desirable behaviour, such as saving for long term, and taking insurance. So these will figure in our discussions.

Concept of income tax

This is extremely simple. It simply balances your tax dues (what you need to pay), with your tax credit (what you pay, or what someone pays for you). The process of balancing the two sides and providing this information to the Tax Department is called Filing of Tax Returns. Both sides are calculated for every Financial Year, which stretches from 1 April of one year, to 31 March of the next.

Declaring income

The more interesting is the dues part, since that is what we earn. You can get a good sense of this side, by taking your Bank statement for the year, and adding all credits. Of course, in case of redemption of an investment, you should add only the gain and not the full amount. This is only a rough estimate, but it does give you a sense. 

The entire game in the dues part is to reduce its weight (of course, one way to do this is to earn less, but that isn't something we are looking to do!). The way to do this is to avail rebates and concessions provided by the Government. These follow the principles above - of encouraging long term savings and investments. These give the upward force necessary to keep the scale relatively light, without reducing income itself. You can look up the exact list of investments and amount of rebate in the Ready Reckoner.

Calculating tax paid

The other part, if well managed, takes care of itself. If you tell your employer about your rent, home loan and tax saving investments accurately, he will take care of the right side, to almost exactly balance the left. He deducts taxes from your monthly pay, and gives it to the government. This is known as TDS (Tax Deducted at Source). He may ask you for proofs of your loan, tax saving investments, etc to make sure he has calculated the TDS right.

There are two items of income an employer obviously cannot calculate for you. These are things you do by yourself - investing in shares or funds; and earning interest on bank accounts and deposits. In case of deposits, the Bank deducts a similar TDS and pays it to the Government. However, unlike the employer TDS, this is not accurate. You need to do your own calculation of income, vis-à-vis TDS paid. If it is found that the TDS paid is less, you pay what is called Advance Tax to bridge the shortfall. We shall look at separately, some common sets of confusion that arise regarding TDS.

Tax returns

Once in the year, you balance these two parts during Tax Filing. This process is nowadays completely online - we look at the simple process for filing returns for salaried people in a separate article. This needs to happen before 31 July, for the Financial Year ended 31 March.

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