The government is banking on tax cuts to boost consumption. What if it doesn’t pan out? #IndiaFinance

The government can boost consumption in the economy in two ways. The first, and more direct, method is for the government to itself spend more, on areas like infrastructure, or social programmes like the rural-employment programme. The second, more indirect, way is to do what the government did: cut taxes, leave more money in the hands of consumers, and hope that they spend that extra money.

Spending on an infrastructure project, for example, leads to jobs being created. Workers on such a project add to the overall size of the consumption spend in the economy with the income they earn. Consumer spending out of new earnings, or through tax cuts, add to the bottom line of the corporate sector, making it more willing to invest in new plants and machinery, and to hire more workers. Thus, a virtuous cycle of spending is created, which creates more jobs, which creates even more spending, and so on. The finance minister is only the latest in a long line of ministers, both in India and abroad, who hope that cutting taxes will stimulate consumption—and, by extension, growth.

Of the two options, it’s clear the government, for now at least, has chosen the second one. As Mint pointed out in a recent article, beyond the headline-grabbing tax cuts, the government budget has reduced the size of the budget this year relative to GDP in its attempt to meet earlier promises of a reduction in the fiscal deficit. Since 2021-22, the government has increased its intake from taxes and revenue by about 0.4 percentage points of GDP, while cutting expenditure by 1.9 percentage points.

Since 2021-22, the government has increased its intake from taxes and revenue by about 0.4 percentage points of GDP, while cutting expenditure by 1.9 percentage points.

Sitharaman said the government will ‘lose’ about ₹1 trillion in revenue as a result of the latest round of tax changes. Yet, the government still expects its income tax revenues to grow by 14.4% next year. As many observers have pointed out, the implicit assumption is that the consumption kick from lower taxes causes the GDP to grow at a much faster rate than it would have, had the tax cuts not taken place, through the virtuous cycle outlined above. Will it work? The answer flows through two questions.

The impact

The intellectual heritage of this line of thought—cutting tax rates can promote growth, and conversely raising taxes can hinder it—stretches right back to 18th-century economist Adam Smith, a pioneer in modern economics. But it depends on a set of assumptions.

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The first assumption is that the tax cut affects a large proportion of the economy so that a substantial proportion of the population changes its behaviour. The government’s own data shows that about 75.5 million individuals filed an income tax return for the assessment year 2023-24 (for income earned in 2022-23). Assuming that the vast majority of such filers are at the top end of the income distribution, this amounts to little more than 5% of the Indian population.

But of these 75 million who filed a return, only around 28 million actually paid any income tax. The bulk of the remainder would have fallen below the tax threshold. So, claims about tax cuts for the ‘middle class’ notwithstanding, the actual number of taxpayers in the country amounts to little more than 2% of the population. This is the actual proportion of the population roughly affected by this tax cut.

But by virtue of being the highest earners in the economy, this 2% of the population accounts for a much higher proportion of total incomes earned in the economy across all households.

The income-tax department releases statistics about the number of individual filers and the incomes declared by them and taxes paid. In the assessment year 2023-24 (the latest year for which the data is available), individuals declared ₹61 trillion of income from all sources (salaries, capital gains etc.) before tax. Adjusted for tax paid, this amounted to ₹55 trillion.

This total post-tax income was 20.4% of the nominal GDP in 2022-23. In 2011-12, this share was 12.6% of nominal GDP. In other words, the top income-earning segment of the economy has seen its incomes rise much faster than the overall economy over the last decade or so. Note that these numbers include those who filed a return, but did not pay any tax as they fell below exemption limits (see chart).

Assuming that this share of top income earners in the GDP remains relatively stable for financial years 2023-24 and 2024-25, and using the GDP projections in the budget, it’s possible to estimate that the tax filer segment of the economy will earn around ₹73 trillion in the coming financial year, assuming the tax cuts hadn’t happened. If we add in the tax cuts of ₹1 trillion, that amounts to an increment of 1.3% in taxpayer incomes. The actual bump to consumption will be less than that. For every extra rupee earned, on average, about 80 paise goes towards additional spending, with the balance being saved.

But because of the virtuous cycle outlined earlier, a single rupee in additional spending causes a ‘multiplier’ effect on overall GDP. Even assuming a generous multiplier of five times, we end up with an additional ‘kick’ or growth in nominal GDP of around 1.1%.

Are tax rates high?

The second implicit assumption is that taxes on top income earners are so high that cutting them will have a noticeable impact on spending, and boost overall growth, and add to tax revenue. Even aside from the relatively small size of the boost to taxpayer incomes from the tax cut, will this happen?

The most notorious and extreme proponent of this claim was economist Arthur Laffer. In the mid-1970s, he sketched out his so-called ‘Laffer Curve’ in the shape of an inverted-U, showing that beyond a point, raising tax rates actually caused a reduction in tax revenue. Very high tax rates would cut into consumer budgets, reduce spending and growth, and lead to the economy slowing down. Economic weakness would lead to a fall in incomes, causing tax revenue to fall as well. Conversely, therefore, cutting such high taxes will actually cause a boost to the economy—large enough so that it actually results in higher tax revenue for the government, even as taxpayers are better off.

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In theory, this is possible. If, on average, a taxpayer faced taxes of 80% of income, consumer spending would undoubtedly take a hit, though the government could always transfer that extra revenue into the pockets of non-taxpayers through welfare schemes. Thus, even in this case, there would be a virtuous cycle for the rest of the economy.

Actual evidence for the ‘Laffer Curve’ is weak, to say the least. Research for the US—which has a much wider income tax base than India, with a far greater proportion of the population within the tax net—points to a tax rate as high as 70% where this ‘free lunch’ effect kicks. That is, only when tax rates are above this level does revenue fall.

Average tax rates for India are nowhere near that level. From the income tax data, it’s possible to calculate a very rough estimate of average tax rates paid by those who do pay taxes (excluding zero tax return filers). That’s around 15-18% of income, well below any estimates of tax rates that would result in the Laffer Curve effect.

What if it doesn’t work?

Using the tax data, it’s possible to look at how the incomes of tax-filers alone (top 5% of the population) have grown, relative to that of the rest of the population. To do this, we took the total household disposable income in the economy calculated by the government from GDP data and deducted post-tax incomes of tax-filers (the total gross income declared by such individuals in income tax statistics, adjusted for the taxes paid) to arrive at the total income of non-tax filers. Dividing through each of these by the respective populations gives us an idea of the average incomes in each group.

In 2022-23, the average non-tax filer earned ₹1.11 lakh per year, or ₹9,329 per month (without adjusting for inflation). In that same year, tax filers earned 6.5 times more, or ₹60,744 per month.

Chart 2 shows this data, but adjusted for inflation, using the Consumer Price Index (CPI)-Urban for tax filers and CPI-Combined for the rest.

By comparison, the Household Consumer Expenditure Survey for 2022-23 estimated a monthly consumption expenditure (not income) in nominal terms at ₹3,773 a month for rural areas, and ₹6,459 a month for urban areas.

In overall revenue terms, as the Mint article points out, the government is in a good spot, having received substantial dividends from the Reserve Bank of India and healthy tax revenue in its latest budget estimates. The government has managed to beat its tax collection targets for four years in a row, and so can afford to pass on some of that extra revenue back to taxpayers.

But even as taxpayers saw a tax cut, key government programmes such as rural employment guarantee programme (MGNREGS) or income transfer to farmers (PM-KISAN) saw little to no growth, even as overall spending on social sectors has declined in recent years. The government’s big capex push has not delivered on its promises, and has flattened out in the latest budget as well. The emphasis seems to be toward reducing the fiscal deficit, rather than using those healthy revenue toward social programmes.

There can be a flip side to this. The implicit assumption underlying tax cuts and reduced social spending seems to be that the consumption boost will have knock-on effects across the economy, even improving incomes and consumption of non-taxpayers. If it doesn’t pan out, the government may well have to overcompensate in future years. Weak economic growth will lead to economic distress and a greater need for social spending to alleviate distress. This will need increased tax revenue to support that, and possibly higher taxes.

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