THERE IS A virtual tsunami of opinions on the historically unprecedented changes in the personal income tax (PIT) announced by Finance Minister Nirmala Sitharaman for the fiscal year 2025-26 (FY26). The accolades are well deserved. To be bold enough to more than double the exemption limit and take a revenue hit of Rs 1 lakh crore shows exceptional fiscal courage. The budget attempts to achieve the difficult triple objective of reducing the fiscal deficit, maintaining the level of public capital expenditure, and handing a tax bonanza to the middle class.
Some commentators, including my friend Krishnamurthy Subramanian (KS), the former chief economic advisor in the Ministry of Finance, have argued that the revenue loss of Rs 1 lakh crore will be more than compensated by the growth of Rs 5 lakh crore in national income through the operation of the consumption multiplier. In a recent article (Tax cuts will have multiplier effects,’ IE, February 7), KS argues that the rise in the disposable income of about 3.1 crore taxpayers as a result of the higher tax exemption and re-jigging of tax rates, by 0.3 per cent of the GDP, will result in an increase in consumption by 3.2 per cent and an increment of 1.8 per cent in the GDP. 1 wish that these eye-popping numbers were actually correct. Unfortunately, however, even a preliminary inquiry into the assumptions underlying these estimates, reveals them to be hyperbolic.
KS’s assumption of the marginal propensity of consumption (MPC) of 0.8 per cent or even 0.7 per cent for those paying the personal income tax (PIT) is far too high on several counts. First, higher income segments of taxpayers, also benefitted by the exemption and reduction in tax rates, have a higher propensity to save, which lowers their MPC. Second, consumption by these income groups includes a significant proportion of imported goods and services, which results in consumption leakage lowering the domestic economy’s MPC. Third, a rise in disposable income could be expected to encourage debt repayment which also raises the effective savings rate. Thus, a MPC closer to 0.5 per cent is a more realistic assumption. The rise in disposable in- come by Rs 1 lakh crore will, therefore, result in an increase of Rs 2 lakh crore in national income and not of Rs 5 lakh crore.
Furthermore, KS applies the increase in nominal disposable income to the real consumption and GDP levels to estimate the positive impact of the rise in disposable incomes. This is a mistake as the increase in disposable income should be seen in relation to nominal levels of expected consumption and GDP in FY2025-26. The nominal consumption level in FY26 is estimated to be Rs 200 lakh crore and the nominal GDP is estimated to be Rs 324 lakh crore. Therefore, with the more realistic MPC of 0.5 per cent and the resultant rise in consumption by Rs 2 lakh crore, the actual consumption growth will be 1 per cent (2 divided by 200) and the growth in GDP will be only 0.6 per cent.
These estimates are far more realistic. They yield a growth in GDP of 0.6 per cent, which is double the increase in disposable income of 0.3 per cent of GDP. This still shows a robust consumption multiplier at work. The finance minister should be complimented for taking this growth inducing fiscal step that will likely have a positive impact on investment sentiments and help trigger a rise in private capacity- building investment.
The loss in direct tax revenue could result in either a compression of public capital expenditure or an increase in government borrowings, thereby forcing the government to abandon the target for the reduction in fiscal deficit. There is a visible slowdown in government public capex in the budget estimates for FY26. Capital expenditure is slated to be Rs 11.2 lakh crore in FY26, virtually the same as the budget estimate for public capex in 2024-25 of Rs 11.11 lakh crore. With nominal GDP expected to rise by 10.1 per cent, this implies a decline in public capex as a share of GDP. This will imply a lower investment multiplier compared to the previous two years and will weaken the overall growth impact of the consumption multiplier.
The persistent and principal weakness in the country’s current economic situation is the tepid performance of private investment over the last few years. This weakness in private investment could result in a weak supply response to the rise in private consumption demand spurred by the rise in disposable incomes and the lowering of the repo rate by the RBI by 0.25 per cent. This could result in spiking inflationary expectations in the economy, which is certainly avoidable. Therefore, the key policy measure for realising a consumption-driven acceleration in GDP growth is to catalyse private investment by improving the investment climate in the country.
In this context, the more important measure announced in the budget is the setting up of a high-level committee to identify the regulatory and compliance burden for private investors and recommend measures for eliminating them. Given the critical nature of implementing these measures to restore investor confidence, the finance minister should chair this committee. Measures to root out petty but widespread rent-seeking: reduce investor harassment and eliminate the prevailing uncertainty require the highest possible level of political backing. The committee could also include state finance ministers. Such a committee will send the strongest signal that this government perceives itself as a promoter and supporter of private investors and will do whatever is necessary to release the latent animal spirits, thereby ushering in an era of rapid and sustained economic growth.
ABOUT THE AUTHOR
Rajiv Kumar is formerly vice chairman, Niti Ayog, and presently chairman, Pahle India Foundation. This article was first published in The Indian Express. Published here with the author’s permission.
