Progressive Tax Systems: Marginal Vs. Effective Rates Demystified - Part II

3. Phase-outs, cliffs, and stealth taxes that raise hidden liabilities

1. Phase-outs: vanishing rebates and deductions

Indian tax law embeds several phase-outs that quietly raise the effective tax burden as income climbs.

The most visible example is the Section 87A rebate under the new regime: it wipes out tax liability up to ₹7 lakh in FY 2024-25 and up to ₹12 lakh from FY 2025-26, but the benefit shrinks rupee-for-rupee once income breaches those limits, creating an implicit marginal rate of 100 percent until the rebate is fully clawed back.^[11] To soften the blow, Budget 2025 introduced “marginal relief,” ensuring the extra tax never exceeds the extra income within the ₹12–12.75 lakh band.^[12] Phase-outs also lurk in deductions: the enhanced standard deduction of ₹75,000 disappears once income rises above the rebate zone, and popular deductions under Sections 80C (₹1.5 lakh), 80D (₹25,000-₹50,000) and 80CCD(1B) (₹50,000) are capped, so their value erodes as a share of total income.

For taxpayers, these gradual tapers feel painless, yet they silently push the true marginal tax rate well above the headline slab.

2. Tax cliffs: sudden liability spikes

Where phase-outs are a dimmer switch, tax cliffs behave like a trapdoor—one rupee too many and a large liability kicks in. Without marginal relief, earning ₹12,00,001 in FY 2025-26 would have triggered a ₹60,000 tax bill that did not exist at ₹12,00,000, an effective marginal rate of six million percent!^[13] Bigger cliffs lurk higher up the income ladder.

Crossing ₹50 lakh, ₹1 crore, and ₹2 crore triggers 10 percent, 15 percent, and 25 percent surcharges, respectively, adding as much as 7.4 percentage points to the statutory rate in a single step.^[14] Because the 4 percent Health & Education Cess applies on top of the surcharge, the all-in statutory rate can jump from 30 percent to almost 39 percent overnight.

Although marginal relief also tempers surcharge cliffs, the short income bands over which it operates mean taxpayers can still face four-figure effective marginal rates for small pay rises. Understanding these cliffs is vital when negotiating bonuses, exercising stock options, or timing capital-gain realisations.

4. Capital gains, dividends & strategic loss harvesting under India’s post-2024 tax regime

1. Capital-gain buckets and their updated rates

India’s 2024 Budget drew a sharper line between short-term and long-term capital gains. For listed equity shares and equity-oriented mutual funds, holding the asset for more than 12 months now qualifies as long-term; anything shorter is short-term. Unlisted shares and most immovable property retain a 24-month threshold, while gold and other movable assets keep the 36-month bar.

Long-term gains on listed equities are taxed at a flat 12.5 percent—up from 10 percent—with no indexation, whereas short-term gains face a uniform 20 percent levy if Securities Transaction Tax (STT) is paid.

Because STT-paid trades enjoy concessional rates, investors selling on recognised exchanges must still factor in the marginal STT of 0.017–0.1 percent when comparing after-tax outcomes. The revision deliberately narrows the post-tax spread between short-term trading and patient, long-term investing, nudging retail investors away from intra-year churn toward multi-year compounding.

2. Where dividends fit in—and when they behave like “qualified” income

Since the Dividend Distribution Tax (DDT) was scrapped in FY 2020-21, dividend income is taxed in the shareholder’s own slab, not at the company level. Budget 2025 eased the compliance pinch by doubling the Tax-Deducted-at-Source (TDS) exemption threshold to ₹10 000 per financial year; payouts above that still face a 10 percent TDS (20 percent if a PAN is missing).

Unlike the U.S. concept of “qualified dividends,” India offers no reduced dividend bracket; the rate piggybacks on your total income. That said, investors in the 5 percent or 10 percent slab may find dividends taxed more gently than the 12.5 percent long-term capital-gain rate on equity, whereas those in the 30 percent slab will prefer appreciation over payout.

A practical optimisation trick is to channel high-yield stocks into accounts held by lower-income family members while parking growth-oriented assets in higher-bracket hands—achieving an implicit dividend “qualification” through household allocation rather than statute.

3. Tax-loss harvesting: turning red ink into a refund

Loss harvesting lets you crystallise capital losses before 31 March, then deploy them to offset taxable gains. Current rules allow short-term capital losses (STCL) to be set off against both STCG and LTCG, whereas long-term capital losses (LTCL) can ordinarily offset only LTCG.

Both categories may be carried forward for eight assessment years if disclosed in a timely return. A headline change in the proposed Income-Tax Bill 2025 grants a one-time window—applicable for the 2026-27 tax year—to net LTCL against STCG as well, accelerating relief for investors nursing pandemic-era losses.

To execute the tactic efficiently: 1) repurchase the same security only after a statutory cooling-off day to avoid “wash-sale” reclassification, 2) pair gains and losses within the same asset class to simplify record-keeping, and 3) file Form I-Schedule CG meticulously so the carry-forward ledger survives scrutiny.

References

1. [11] ClearTax guide to 87A rebate
2. [12] HDFC Bank explainer on marginal relief
3. [13] Economic Times analysis
4. [14] Income-tax India surcharge tables