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Chapter 3 Standard Deduction: Rs40,000

Standard Deduction is a flat amount that was cut from the salary/income of an individual until it was abolished in FY2006. Before we get into the nuances of the new standard deduction norms introduced in the Union Budget 2018, it would be prudent to understand how the original standard deduction worked.

How was the old standard deduction calculated?

The old model of standard deduction as a flat deduction from the total income had the following features:

  • For salaried employees earning between Rs. 75,000 per annum (pa) and Rs. 5 lakh pa, the standard deduction was fixed at Rs. 30,000 pa or 40% of the income, whichever was lower.
  • For salaried employees earning more than Rs. 5 lakh pa, the standard deduction was fixed at a flat Rs. 20,000 pa.
  • This standard deduction was only for salaried employees. Hence, people earning pensions, interest income, or business income, could not avail this facility.
  • The standard deduction was given to compensate salaried employees for recurring expenses. For example, self-employed professionals are allowed deductions for routine expenses. The idea of standard deduction was to put the salaried employees at par with self-employed professionals in terms of tax benefits.
  • The advantage of standard deduction was that it was an extremely simple and flat deduction from the total salary income. No details like bills of expenses or invoices were required to avail it and all salaried employees were entitled to this deduction automatically.

Why was standard deduction abolished in Budget 2005?

In the Union Budget 2005, then Finance Minister P Chidambaram had announced the summary abolition of the standard deduction benefit to salaried employees. His argument was that since the standard deduction was in the nature of an allowance, it was naturally taxable and hence, there was no merit in continuing the scheme. With this, the standard deduction stood abolished from 2005 onwards.

Highlights of the 2018 announcement on standard deduction

In the Union Budget 2018, Arun Jaitley reintroduced the standard deduction at a flat rate of Rs. 40,000 pa.

The following are the key highlights of the new standard deduction announcement:

  • The new standard deduction of Rs. 40,000 will be available to all salaried employees irrespective of the income levels. The would continue to remain at a flat rate.
  • This new standard deduction will be in lieu of the exemptions that were earlier offered on medical allowance and transport allowance. Currently, transport allowance up to Rs. 19,200 pa and medical allowance up to Rs. 15,000 pa are permitted as reimbursement against actual production of bills. The medical allowance and the transport allowance benefit will stand abolished with effect from FY19.
  • Pensioners who were not entitled to the standard deduction in the old methodology (until 2005) have also been included under the ambit of the new standard deduction. Moreover, pensioners will be the real beneficiaries of the standard deduction as they anyways do not get transport allowance and medical allowance. Hence, the entire benefit of Rs. 40,000 will be available to them.
  • For salaried employees, the standard deduction of Rs. 40,000 will effectively replace the transport allowance of Rs. 19,200 and the medical allowance of Rs. 15,000 pa. Therefore, the effective benefit to a salaried individual will be to the extent of Rs. 5,800 pa in terms of exemption (40,000-15,000-19,200 = 5800).

Actual benefit of standard deduction to salaried employees and pensioners

The illustration below captures the impact that this shift will have on the net taxable salary income of the individual assessee on a salary income.

Details AY2018-19 AY2019-20
Gross Salary Rs. 650,000 Rs. 650,000
Transport Allowance (Rs. 1,200/month is exempt) Rs. 19,200 Not Applicable
Medical Allowance Rs. 15,000 Not Applicable
Standard Deduction Not Applicable Rs. 40,000
Net Salary post deductions Rs. 615,800 Rs. 610,000
Impact of shift to Standard Deduction -- Net salary reduces by Rs. 5,800 due to standard deduction

The benefit in the above case may not appear to be too attractive when the net impact is considered after adjusting for the forsaken benefits of transport allowance and medical allowance. However, the benefit could be more pronounced in case of pensioners. Check out the illustration below:

Details AY2018-19 AY2019-20
Gross Pension Income Rs. 520,000 Rs. 520,000
Transport Allowance (Rs. 1,200/month is exempt) Not Applicable Not Applicable
Medical Allowance Not Applicable Not Applicable
Standard Deduction Not Applicable Rs. 40,000
Net Income post deductions Rs. 520,000 Rs. 480,000
Impact of shift to Standard Deduction -- Net income reduces by Rs. 40,000 as a result of standard deduction

Thus, it can be observed from the above illustrations that the benefit of standard deduction is much higher in case of pensioners than it is for salaried employees. Nonetheless, the new system is more convenient as claiming standard deduction does not require an employee to produce bills and, consequently, is administratively simpler.

Understanding the impact of standard deduction shift on actual tax payable

One should keep in mind that the introduction of standard deduction has been accompanied with some other changes to the calculation of tax on salary. For example, medical allowance and transport allowance have been scrapped in lieu of standard deduction. On the other hand, the Education Cess has been increased from 3% to 4% in the Union Budget 2018.

What would be the overall impact of all these changes? Let us compare the actual tax calculations between AY2018-19 and AY2019-20.

Tax Calculation on Salary AY2018-19 AY2019-20
Gross Income Rs. 2,825,000 Rs. 2,825,000
Transport Allowance (Rs. 1,200/month is exempt) Rs. 19,200 Not Applicable
Medical Allowance Rs. 15,000 Not Applicable
Standard Deduction Not Applicable Rs. 40,000
Net Income post deductions Rs. 27,90,800 Rs. 27,85,000
Income Tax Calculations
Income Tax Rs. 6,49,740 Rs. 6,48,000
Surcharge 0 0
Education Cess (@2% of tax payable) Rs. 12.995 Not Applicable
Secondary and Higher Education Cess (@ 1% of tax payable) Rs. 6,497 Not Applicable
Education and Health Cess (Combined rate of 4% of tax payable) Not Applicable Rs. 25,920
Total Tax Liability Rs. 6,69,232 Rs. 6,73,920
Additional tax paid under the New Standard Deduction formula Rs. 4,688

In a nutshell, there are two key things that we need to understand about the new standard deduction in the overall picture of your tax calculation.

  • The full benefit of Rs. 40,000 standard deductions is only available to pensioners. In the case of salaried employees, this standard deduction comes in lieu of transport allowance (Rs. 19,200) and medical allowance (Rs. 15,000). Thus, the net benefit for the salaried employees is only Rs. 5,800.
  • The cess on tax has been increased from 3% to 4%. In AY2018-19, there is an education cess of 2% and a higher secondary cess of 1% taking the total cess to 3%. However, in AY2019-20, the cess is combined into an ‘Education and Health Cess’ charged at 4% of the tax payable.

In the above illustration, the tax liability of the individual goes up despite the standard deduction as he has to pay a higher surcharge in AY2019-20. This explains the increase in tax liability for that year.

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