Tax Cut in Budget will have Multiplier Effects

Context: In the Union Budget for fiscal year 2025-26, Finance Minister Nirmala Sitharaman introduced significant reforms to the personal income tax (PIT) structure.

Key Changes in Personal Income Tax

Increased Tax-Free Income Threshold: The tax exemption limit under Section 87A has been raised from ₹7 lakh to ₹12 lahks, effectively exempting individuals earning up to ₹12 lahks annually from paying income tax.

How Tax Cuts in Budget Will Have Multiplier Effects?

• Increase in Disposable Income: The increase in tax exemption limits and reduction in tax rates will put more money in the hands of around 3.1 crore taxpayers.
  • The increase in disposable income due to tax cuts is expected to enhance consumer spending.
  • However, the actual impact depends on the marginal propensity to consume (MPC), which is estimated to be around 0.5% for higher-income groups due to their higher savings propensity and consumption of imported goods.
• GDP Growth: With a more realistic MPC, the rise in disposable income is projected to increase national income by about Rs 2 lakh crore, leading to a GDP growth of approximately 0.6%.
• Boost to Private Investment: Higher consumption can encourage businesses to expand production and invest in capacity-building.
  • Improved demand outlook may also attract new investments.
• Challenges to the Multiplier Effect
  • Savings vs. Spending: Higher-income groups tend to save rather than spend, reducing the overall consumption impact.
  • Import Leakages: Increased spending on imported goods reduces the benefits to the domestic economy.
  • Debt Repayment: Some of the additional disposable income may be used to repay debts, lowering its direct impact on consumption.
• Public Capex Trade-off: The tax cuts result in a revenue loss of ₹1 lakh crore.
  • This could either lead to lower public capital expenditure (Capex) or higher government borrowing, affecting fiscal stability.
• Inflationary Risks: If private investment does not keep pace with rising consumption, demand-supply imbalances may push inflation upwards.

Key Recommendations

• Catalyzing Private Investment: To maximize the benefits of tax cuts, it is crucial to improve the investment climate. This can be achieved by reducing regulatory and compliance burdens for private investors.
• High-Level Committee: Establishing a high-level committee, chaired by the finance minister and including state finance ministers, to identify and eliminate regulatory hurdles can significantly boost investor confidence and stimulate private investment.
• Addressing Rent-Seeking and Uncertainty: Measures to reduce petty corruption, investor harassment, and uncertainty are essential for fostering an environment conducive to rapid and sustained economic growth.
• Maintaining Fiscal Discipline: While tax cuts can stimulate growth, it is important to manage the resulting revenue loss by either maintaining public capital expenditure or ensuring that increased government borrowing does not jeopardize fiscal deficit targets.

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