Tax exemption: Economic relief or revenue risk?

Cuts provide short-term comfort to upper middle class but will in long run raise deficits, drive inequality.

India’s economy has been struggling with a demand problem for quite some time, eventually manifesting in its four-year low of GDP growth at 6.4 per cent in FY25. The Reserve Bank of India (RBI) cut the repo rate by 25 bps, the first rate cut in five years to help stimulate economic growth. However, the biggest step to stimulate demand was taken by Finance Minister Nirmala Sitharaman when she announced that individuals earning up to Rs 12 lakh in annual income would be exempted from paying any direct income tax. This step was a deliberate attempt at boosting the aggregate demand within the economy but its effectiveness is still up for debate.

This income tax relief has been labelled as a masterstroke, like initiatives under this political regime usually are, for the middle class in India. This, essentially, means that individuals earning up to Rs 1 lakh per month are now being considered as middle class. However, the estimated income distribution in India shows that this is a wild overestimate. The middle-class income is characterised by the income of the middle 40 per cent in the income distribution of the country. A joint study by Bharti, Chancel, Piketty and Somanchi showed that the threshold income to be considered middle class is a little over Rs 1 lakh annually and the average income in this group is Rs 1.65 lakh, while the minimum annual income required to be considered in the top 10 per cent of income earners stands at under Rs 3 lakh. This shows that the middle class was already comfortably covered under the initial tax-free bracket of Rs 7 lakh and that raising the bracket to Rs 12 lakh does not benefit the middle class but the upper class.

From a Keynesian perspective, this tax cut can be viewed as an innocent attempt by the government to boost demand by increasing the disposable income available to the upper class. According to Keynesian economics, higher consumption boosts aggregate demand which drives economic growth and a tax relief increases disposable income leading to higher consumption. However, it also states that lower-income households have a higher propensity to consume compared to higher-income households who tend to save the additional income. A recent analysis by Motilal Oswal Financial Services Ltd showed that the beneficiaries of the tax cut would use the money to pay off existing debt instead of consumption, hampering the intended impact of the tax cut on aggregate demand.

Additionally, our misinterpretation of who should be considered middle class might significantly hamper India’s goal of achieving inclusive growth. Given that India follows a progressive tax system, direct income tax plays a key role in wealth redistribution. Hence, a tax cut that disproportionately benefits the upper class under the guise of benefiting the middle class could exacerbate the already daunting problem of inequality within the country.

Indirect taxation slows down growth

Further, the budget’s aim to reduce the fiscal deficit to 4.4 per cent seems a bit ambitious. This will depend on the revenue generated, the growth of the economy, and the fiscal prudence of the government. The fiscal deficit can be reduced by various methods such as debt ceilings, government shutdowns, furloughs, fiscal cliffs, and sequestration. However, the government has placed its bet on Capex which has a huge multiplier effect on growth and employment. An increase in the target on Capex (Rs 11.21 lakh crore) makes the Capex to revenue expenditure ratio high. This will lead to higher borrowings and interest payment burdens which can significantly impact private investment. The resulting growth can enhance revenue collection but it realises in the long run rather than the current fiscal year.

The government might try to solve this problem through indirect taxation. GST is as high as 28 per cent for commodities such as consumer durables and the median rate is already 18 per cent, showing a heavy reliance on Indirect taxation which is regressive. Furthermore, when indirect taxes increase, consumers tend to reduce their demand which creates a vicious circle of higher unemployment, reduced growth, and lower government revenue. For these reasons, countries such as Canada and UAE impose a GST of 5 per cent, Singapore of 9 per cent and China of 13 per cent. These are mostly introduced to make consumption affordable and reduce the burden on middle and poor consumers.

Another source of income for the government that does not affect the middle and lower classes is corporate tax. The figures from the budget show that corporate tax accounted for 17 per cent, GST accounted for 18 per cent and income tax accounted for 19 per cent of the revenue. In a country where progressive tax systems must be utilised heavily while indirect taxation is eased down, we see GST contributions are at par with corporate and income tax.

Alternatively, if the government decides against an increase in indirect taxation, it will have to adjust the books by reducing expenditure. This could mean further inadequate allotment of funds towards important sectors like health and education which are crucial for India. Key sectors like defence, agriculture, and research might also be affected adversely.

One might argue that a reduction in taxation will induce growth, leading to higher corporate profits and higher corporate tax collections. However, these tax cuts will barely impact the effective demand in the economy. The Indian economy would have been better off if the amount of tax foregone was utilised on transfer payments to the lower income classes or critical sectors like health and education. While the present tax cut might seem like a short-term relief to the upper middle class, in the long run, it will lead to rising inequality, increasing deficits, and poor public service delivery.

(Yash is an independent researcher; Subhashree is an assistant professor at Christ deemed to be university, Bengaluru)