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Bold Tax Cuts or a Risky Economic Gamble?
Context:
The 2025 Union Budget has introduced what is arguably the most significant tax cut for the middle class in India’s history.
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- While the tax-paying middle class represents only a small fraction of the population—approximately 2-3%—this policy brings substantial relief to all taxpayers.
- Budgeting is not just about revenue collection; it is also about redistributing income and influencing economic activity through expenditure decisions.
Tax Cuts
- Individuals earning between ₹7 lakh and ₹12 lakh now enjoy a complete tax rebate, a benefit previously limited to those earning below ₹7 lakh.
- For those earning above ₹12 lakh, the exemption limit has increased from ₹3 lakh to ₹4 lakh, along with broader reductions in tax rates.
- As a result, everyone earning over ₹7 lakh stands to benefit, though at a significant cost—an estimated ₹1 lakh crore reduction in tax revenue, which is nearly 8% of the total direct income tax collection of ₹12.57 lakh crore for the current year.
Logic Behind the Tax Cuts
- Increase in Direct Tax: Despite the anticipated 8% decline in effective tax revenue, the Budget projects a 14% increase in direct tax collections.
- Rise in Taxable Income: Achieving this would require a 24% rise in taxable income, significantly outpacing the nominal GDP growth projection of 10.1%.
- This assumption hinges on one of two possibilities: either a substantial increase in the number of individuals earning above ₹12 lakh or a sharp rise in existing taxpayers’ incomes—what economists call tax buoyancy.
- Upward Income Mobility: In an optimistic scenario, the increased exemption limits could signal upward income mobility, leading to higher tax collections.
- However, if income growth is concentrated among the wealthy, it may further deepen India’s existing K-shaped economic recovery, where high-income groups thrive while lower-income groups continue to struggle.
Risk of a Revenue Shortfall
- Pessimistic Scenario: A more pessimistic scenario arises if tax buoyancy does not materialise as expected.
- Given that government expenditure is directly tied to tax revenue, any shortfall will inevitably impact spending.
- FRBM: The Fiscal Responsibility and Budget Management (FRBM) Act imposes strict limits on fiscal deficits, restricting how much the government can borrow to offset lost revenue.
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- In theory, fiscal policy should act countercyclically—expanding during slowdowns and contracting during booms—but strict adherence to deficit targets forces a pro-cyclical approach, amplifying economic slowdowns rather than mitigating them.
- Government’s Commitment: The government’s commitment to deficit reduction is evident in its recent actions.
- Despite concerns over sluggish economic growth, the fiscal deficit target was revised down from 5% (as announced in the 2024 Budget) to 4.8%.
- This reduction was achieved through expenditure cuts amounting to ₹1 lakh crore, falling short of previous spending commitments.
- The 2025 Budget now sets an even lower deficit target of 4.4%, signalling not just fiscal consolidation but outright contraction.
Fiscal Consolidation or Economic Contraction?
- The Finance Minister’s aggressive deficit reduction strategy raises concerns about its impact on economic growth.
- If a 4.8% deficit failed to drive a turnaround, a 4.4% deficit is unlikely to fare any better.
- Economic recovery requires external stimuli such as exports, corporate investment, or government spending.
- With fiscal policy becoming increasingly restrictive, the government is now relying on private sector investment and exports to drive growth.
- However, if corporate investment has not picked up despite previous tax cuts and capital expenditure incentives, there is little reason to believe that income tax cuts alone will spur significant economic activity.
- The assumption appears to be that lower taxes will boost consumption, which will, in turn, drive investment and create a self-sustaining growth cycle.
- Yet, placing all hopes on a single strategy is a high-risk gamble, particularly when global demand remains weak, as highlighted in the 2025 Economic Survey.
The government’s decision to prioritise tax cuts over direct public investment represents a fundamental shift in economic strategy. While the move provides immediate relief to the middle class, its long-term success depends on whether it can generate the expected rise in incomes and tax collections.
