
Will the personal income tax cuts bring home the consumption bacon?
That's the question doing the rounds following Finance Minister Nirmala Sitharaman's trailblazing tax measures last week.
Preliminary estimates indicate that the Rs 1 lakh crore worth tax revenue foregone due to personal income tax cuts will likely add Rs 14.8 lakh crore worth national output, or add roughly Rs 10 lakh crore to private consumption in FY26. If so, a little, can indeed, go a long way. How?
According to KV Subramanian, Executive Director, IMF India, FY26 consumption will increase at least by about 10% and GDP growth rate will leap to 8% as against the projected 6.3%-6.8%, thanks to the across-the-board tax cuts. Given that the first advance estimates peg real consumption at 7.3% to Rs 104 lakh crore for FY25, a 10% increase in a base case scenario translates to an additional demand worth Rs 10 lakh crore in FY26, with real consumption printing at Rs 114.45 lakh crore or thereabouts in FY26.
Likewise, FY25 real GDP is pegged at Rs 184.88 lakh crore and a 8% growth rate will likely add Rs 14.8 lakh crore worth output to settle at Rs 199.7 lakh crore in FY26. On the other hand, a growth rate of 6.3% will only add Rs 11.6 lakh crore, while 6.8% growth rate will add Rs 12.6 lakh crore.
But here's the thing. These are purely back of the envelope calculations and whether we can crack it is highly uncertain right now. For, the government's two counter-cyclical fiscal measures in the past decade barely delivered. If the 2019 corporate tax rate cuts failed to create as many jobs and improve wages, the unprecedented increase in capital expenditure in the past four years didn't unleash animal spirits as widely anticipated, though it did hold up growth rates.
So it's with a sense of purpose and energy that Sitharaman shifted away from supply-side measures to demand-side doles, sacrificing the sums that would have otherwise been diverted towards capex.
Going for the whole shebang, she reduced personal income tax rates to zero for all those earning up to Rs 12.75 lakh per annum, benefiting over 80% individual taxpayers, besides lowering tax slabs and rates, giving people more after-tax income that could be used to buy goods and services, or go into savings and investments.
The idea is to spur economic activity that's projected to slow down to a 4-year low of 6.4% in FY25, with the grim state of affairs expected to stretch throughout next fiscal. Unhelpfully, the Economic Survey projected a moderate 6.3%-6.8% GDP growth rate for FY26.
The Indian economy has been constrained on all the four growth pillars namely consumption, investments, government spending and exports. Among all, consumption has been the biggest growth setback, leaving untold impact on growth and a counter-cyclical policy comprising tax cuts is the right tool to address demand issues.
As the Economic Survey noted, urban consumption has been relatively weaker than rural consumption and so a tax break to the salaried class may revive discretionary spending. That said, some argue that the proposed increase in GDP growth rate of over 8% next year could be a one-time increase, and growth rate will eventually narrow down, notwithstanding the impact of the eighth pay commission, which is expected early next year.
Economists are also divided on whether tax cuts are a more effective countercyclical policy instrument than government spending. Some argue that cutting taxes does not boost growth nor lead to more taxes being collected. The notion that it does, known as the Laffer Curve hypothesis, has been widely discredited, with former US President George H W Bush describing it as voodoo economics.
Personal income tax collections are by far the largest component of total tax revenues and some argue that if tax cuts are not financed by immediate spending cuts, they will likely also result in an increased budget deficit, which in the long-term will reduce national savings and raise interest rates. The net impact on growth is uncertain, but many estimates suggest it's either small or negative.
The other Keynesian perspective is that public expenditure acts as a stabilizing force and that fiscal policy should lower taxes and increase expenditure during downturns to increase aggregate demand. But Sitharaman's latest budget has significant expenditure compression to make up for the potential loss of income tax revenue and to meet the fiscal deficit of 4.4% of GDP in FY26.