Tax Regime

How Does Tax Regime Work? Employee Tax Guide

A tax regime is a set of laws governing the imposition and computation of taxation within a country or jurisdiction. It encompasses the rules that determine how much tax individuals and entities owe, what types of taxes they pay, and the methods used for tax calculation for specific taxpayers.

Tax regimes establish the framework for both tax collection and management, providing the structure through which governments fund public services, infrastructure, and other societal needs.

Tax regimes vary widely based on several factors including the types of taxes covered, the tax bases addressed, exemptions allowed, and calculation methods employed. The specific structure of a tax regime directly affects the financial planning of individuals, businesses, and corporations by determining their tax obligations on income, profits, property, and other taxable aspects.

Within a tax regime, there are typically two major categories of taxes:

• Direct taxes: These are taxes paid directly to the authority that imposes them, such as income tax, corporation tax, wealth tax, capital gains tax, and securities transaction tax
• Indirect taxes: These are levied on goods and services and include GST, sales tax, excise duty, VAT, service tax, and custom duty. In these cases, an intermediary collects the tax on behalf of the government

Although “tax regime” and “tax system” are often used interchangeably, there exists a subtle difference between the terms. The tax regime specifically refers to the way taxes are levied (for example, progressive, flat, or regressive), while the tax system encompasses all rules, policies, and enforcement mechanisms governing tax collection. For instance, in a progressive tax regime, the tax system might include specific laws on income tax brackets, tax credits, deductions, and collection procedures.

In India, there are currently two tax regimes in operation – the old and the new. The Finance Act 2023 amended the provisions of Section 115BAC to make the new tax regime the default option for individuals, HUFs, AOPs (not being cooperative societies), BOIs, and Artificial Juridical Persons beginning from Assessment Year 2024-25. Nevertheless, taxpayers retain the option to opt out of the new regime and choose to be taxed under the old regime.

The old tax regime refers to the existing tax structure that existed before the introduction of the new regime. It features higher tax rates but permits various deductions and exemptions under different sections of the Income Tax Act, making it potentially beneficial for those with significant investments. Conversely, the new regime offers lower tax rates but eliminates most deductions and exemptions.

Understanding one’s tax regime is essential for compliance with tax laws and regulations. Tax compliance involves paying the correct taxes on time according to state, federal, and international tax laws. Failure to comply with tax obligations may result in penalties and legal complications. Therefore, regardless of which regime applies, it remains crucial for working professionals to adhere to the tax laws imposed by the government and regulatory authorities.

How Does a Tax Regime Work?

Tax regimes function through structured frameworks that determine how much tax individuals and businesses must pay based on their income levels. The core operational mechanism of a tax regime is the slab system, whereby different income brackets are taxed at varying rates. In most systems, these rates typically increase as income rises, establishing a progressive taxation structure.

The fundamental working principle of a tax regime involves categorizing taxable income into predetermined slabs with corresponding tax percentages. For instance, under the new tax regime in India for FY 2025-26, income up to Rs. 4 lakh is not taxed, income between Rs. 4-8 lakh is taxed at 5%, income between Rs. 8-12 lakh at 10%, continuing upward to 30% for income above Rs. 24 lakhs. This structured approach ensures that taxation is distributed based on earning capacity.

Furthermore, tax regimes incorporate various components that affect the final tax liability:

• Rebates: These reduce tax liability for lower-income brackets. In the new tax regime, a rebate of Rs. 60,000 applies, making income up to Rs. 12 lakh tax-free.
• Surcharges: Additional taxes apply to high-income earners, with rates ranging from 10% for incomes between Rs. 50 lakh and Rs. 1 crore, to 37% for incomes above Rs. 5 crore under the old regime. However, the highest surcharge rate has been reduced to 25%under the new tax regime.
• Deductions and Exemptions: These vary significantly between regimes. The old tax regime allows for various deductions under sections like 80C, 80D, and exemptions under section 10. Consequently, the tax regimes function differently when calculating the final tax liability.

In India, primarily two parallel tax regimes operate simultaneously. The Finance Act 2023 established the new tax regime as the default option, though taxpayers can opt out and choose the old regime. For individuals without business income, this choice can be made annually while filing the income tax return. Essentially, taxpayers must compare their potential tax liability under both regimes to determine which is more beneficial.

The operational mechanics of choosing between regimes differ based on income source. For those with non-business income, the option can be exercised directly in the ITR filed before the due date specified under section 139(1). Conversely, taxpayers with business income must submit Form 10-IEA by the due date if they wish to opt for the old regime.

The actual tax calculation process initially considers gross income from all sources, including salary, house property, capital gains, business income, and other sources. Subsequently, applicable deductions are subtracted based on the chosen regime to determine the taxable income. This amount is then subject to the applicable tax rate as per the relevant slab structure, with additional components like surcharge and education cess applied where applicable.

Notably, certain incomes receive special treatment regardless of the regime chosen. For example, long-term capital gains under section 112A and income from special sources like online gaming are taxed separately at specified rates and are not eligible for regime-specific benefits like rebates.

The operational efficiency of a tax regime is typically measured by its ability to balance revenue generation with equity considerations, alongside minimizing compliance burdens and economic distortions.

Types of Tax Regimes

Tax regimes around the world generally fall into four primary categories, each with distinct characteristics that impact taxpayers differently based on their income levels and business structures.

Progressive Tax Regime

Progressive tax regimes apply higher tax rates as income increases. Under this structure, individuals with higher earnings pay a larger percentage of their income in taxes compared to those with lower incomes. The income tax system in the United States exemplifies this approach with seven tax brackets ranging from 10% to 37%. The fundamental principle behind progressive taxation is that a flat percentage would place disproportionate financial burden on lower-income individuals.

The first modern progressive income tax appeared in Great Britain in 1798, introduced by Prime Minister William Pitt the Younger, with rates ranging from 0.83% on annual incomes over £60 to 10% on incomes exceeding £200. By the mid-20th century, most countries had adopted some form of progressive taxation.

Proponents of progressive taxation argue that it reduces the burden on those least able to pay while collecting more revenue than flat or regressive systems. Additionally, this approach leaves more disposable income with lower-wage earners who are likely to spend it on essential goods and services, potentially stimulating economic growth.

Flat Tax Regime

A flat tax regime applies a single tax rate to all taxable income regardless of the amount earned. Unlike progressive systems with multiple brackets, flat taxes feature only one non-zero rate. Several variations exist, including:

• True flat-rate tax: Applied to all personal income with no deductions
• Marginally flat tax: Allows deductions, making it progressive up to the maximum deduction point
• Modified flat tax: Permits very few deductions while eliminating most others
• Capped flat tax: Applied until a specified maximum amount is reached

Russia represents the largest nation using a flat tax, with a 13% rate on personal income. After implementing this system in 2001, Russia’s real revenues from personal income tax rose by 25.2%in the first year, followed by increases of 24.6% and 15.2% in subsequent years. Other countries employing flat tax systems include Hungary, Romania, Bolivia, and Greenland, which applies a substantial 45% flat rate.

Regressive Tax Regime

Regressive tax regimes create a structure where the tax rate effectively decreases as taxable amounts increase. In practical terms, low-income earners pay a higher percentage of their income in taxes than middle or high-income individuals. Common examples include sales taxes, excise taxes, tariffs, user fees, and certain property taxes.

To illustrate this effect: if two people each purchase INR 8,438 of clothing with a 7% sales tax, both pay INR 591 in tax. Yet for someone earning INR 168,761 weekly, this represents just 0.35% of their income, whereas for someone earning INR 27,002, it constitutes 2.2%. In Brazil, families earning up to twice the minimum wage spend 48.8% of their income on taxes, while those earning more than 30 times the minimum wage pay only 26.3%.

Social Security taxes often function regressively because they typically apply as a flat percentage on wages up to a certain threshold, exempting earnings above that cap.

Corporate Tax Regime

Corporate tax regimes specifically govern how business entities are taxed on their profits. In India, domestic companies are taxed on worldwide income, while foreign companies are taxed only on income earned within India.

For the 2025-26 tax year, Indian corporate tax rates vary significantly based on company type and earnings:

• Domestic companies with turnover under INR 4 billion: 25% basic rate (effective rates 26-29.12% including surcharges)
• Other domestic companies: 30% basic rate (effective rates 31.2-34.94%)
• Foreign companies with permanent establishment in India: 35% basic rate (effective rates 36.4-38.22%)

Additionally, beneficial rates exist for certain companies, including a 22% rate (plus 10% surcharge) for existing domestic companies meeting specific conditions and a 15% rate (plus 10% surcharge) for newly established domestic manufacturing companies. If tax liability under normal provisions falls below 15% of book profits, companies may be subject to Minimum Alternate Tax at 15%.

How Tax Regimes Affect Employees

The Finance Act 2023 made the new tax regime the default option for employees, fundamentally altering how salary taxation operates in India. Employees now experience different tax implications based on their regime choice, primarily affecting their take-home salary and tax planning strategies.

Regarding salary structure, the new tax regime offers more favorable tax slabs but eliminates most exemptions and deductions. Standard deduction of Rs. 50,000 remains available under both regimes, preserving this benefit for all employees. Moreover, the regime selection directly impacts how employers calculate Tax Deducted at Source (TDS).

For salaried individuals, the choice between regimes must be communicated to employers at the beginning of each financial year. When employees fail to provide this information, employers must automatically apply the default new regime for TDS calculations. Indeed, this communication only affects TDS deduction and doesn’t constitute the final regime selection, which occurs during return filing.

The impact on housing benefits is particularly significant. House Rent Allowance (HRA) exemptionunder section 10(13A), vital for many urban employees, is unavailable in the new tax regime. Likewise, interest on borrowed capital for self-occupied property cannot be claimed as a deduction under the new regime, potentially affecting employees with home loans.

Currently, the two regimes offer differing benefits based on income levels and investment patterns:

• Employees with income up to Rs. 7 lakh receive a rebate of Rs. 25,000 under the new regime, making their tax liability zero
• In contrast, the old regime offers a rebate of only Rs. 12,500 for income up to Rs. 5 lakh
• For FY 2025-26, the rebate increases to Rs. 60,000 under the new regime

Senior citizen employees gain distinct advantages. In the old regime, they enjoy higher basic exemption limits (Rs. 3,00,000 for seniors, Rs. 5,00,000 for super seniors), whereas the new regime makes income up to Rs. 7 lakh tax-free for all age groups.

Alongside these differences, some benefits persist across both regimes. Deduction for employer’s contribution to NPS accounts is permitted in both systems, with the new regime actually allowing a higher percentage (14% versus 10% under the old regime).

Ultimately, salaried employees have greater flexibility in regime selection, as they can switch between regimes each year when filing returns, unlike business owners who face restrictions after opting out of the new regime.

Old vs New Tax Regime for Employees

In relation to employee taxation, India currently operates two parallel tax regimes with distinct structures. The choice between these regimes directly affects an employee’s take-home salary and tax planning strategies.

Key differences in tax slabs

The new tax regime features lower tax rates across more slabs yet offers a higher basic exemption limit. Under this structure, no income tax applies up to Rs. 7 lakh due to a rebate of Rs. 25,000, in contrast to the old regime’s rebate of only Rs. 12,500 for income up to Rs. 5 lakh.

For FY 2025-26, the new regime introduces these tax slabs: income up to Rs. 4 lakh is untaxed, followed by 5% on Rs. 4-8 lakh, 10% on Rs. 8-12 lakh, 15% on Rs. 12-16 lakh, 20% on Rs. 16-20 lakh, 25% on Rs. 20-24 lakh, and 30% beyond Rs. 24 lakh.

Concerning age-specific benefits, the old regime maintains separate exemption limits for senior citizens (Rs. 3 lakh) and super senior citizens (Rs. 5 lakh), whereas the new regime applies uniformly across age groups.

Impact on deductions and exemptions

The fundamental distinction between regimes lies in available deductions. The old regime permits numerous exemptions, including:

• HRA exemption under section 10(13A)
• Investment deductions under sections 80C, 80D, 80G
• Home loan interest deduction up to Rs. 2 lakh for self-occupied property

In contrast, the new regime eliminates most deductions apart from:

• Standard deduction (increased to Rs. 75,000 in FY 2024-25 from Rs. 50,000)
• Employer’s contribution to NPS under section 80CCD(2)
• Contributions to Agniveer Corpus Fund under section 80CCH

Who should choose which regime?

Selecting the appropriate regime depends on an employee’s financial situation. Salaried individuals with minimal deductions typically benefit from the new regime’s lower tax rates. Alternatively, those claiming substantial deductions through investments, home loans, or HRA typically find the old regime more advantageous.

For precise determination, employees should perform a comparative evaluation under both regimes. The Income Tax Portal provides a calculator for estimating tax liability under each option.

Employees without business income enjoy the flexibility to switch between regimes annually when filing returns. For FY 2023-24 onward, the new tax regime functions as the default option unless an employee explicitly opts out.

Why Understanding Your Tax Regime Matters

Understanding which tax regime applies to your situation fundamentally affects your financial planning and long-term wealth creation. Proper knowledge of tax regimes enables informed decisions regarding your finances, ultimately optimizing tax liabilities while ensuring compliance with regulations.

Selecting between regimes is not merely about minimizing taxes—it involves making your money work smarter. The choice directly influences take-home pay, savings potential, and investment strategies. For salaried individuals, knowing your tax regime helps determine whether claiming deductions through investments like PPF, NPS, or ELSS would benefit you.

Proper tax regime comprehension assists in avoiding notices from tax authorities by ensuring compliance with applicable provisions. Furthermore, it provides better resource allocation toward savings or investments, potentially boosting long-term financial stability.

The impact of regime selection varies based on individual circumstances. For taxpayers with income up to ₹24 lakh claiming few deductions, the new regime typically offers greater benefits. Alternatively, high-income earners utilizing significant deductions under Section 80C, home loan interest, or insurance premiums may find the old regime more advantageous.

Ultimately, thorough evaluation using income tax calculators helps compare tax liability under both regimes. Since the Finance Act 2023 made the new regime default, taxpayers must actively opt out if they prefer the old regime—highlighting why understanding these systems remains essential.

Key Takeaways

Understanding tax regimes is crucial for employees to optimize their financial planning and ensure compliance with tax obligations. Here are the essential insights every employee should know:

• Two regimes, one choice: India operates old and new tax regimes simultaneously, with the new regime as default since 2023, but employees can switch annually when filing returns.

• New regime trades deductions for lower rates: Offers reduced tax rates (0% up to ₹7 lakh) but eliminates most deductions like HRA and 80C investments.

• Old regime favors high deduction users: Better for employees claiming substantial deductions through home loans, investments, or HRA exemptions despite higher tax rates.

• Income level determines optimal choice: Those earning up to ₹24 lakh with minimal deductions typically benefit from new regime’s lower rates and higher exemption limits.

• Calculate before deciding: Use tax calculators to compare liability under both regimes, as the optimal choice varies based on individual financial circumstances and investment patterns.

The key is evaluating your specific situation—income level, investment habits, and available deductions—to determine which regime maximizes your take-home pay and supports your long-term financial goals.

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