Why the tax Cuts are a One-Way Gamble
- February 5, 2025
- Posted by: OptimizeIAS Team
- Category: DPN Topics
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Why the tax Cuts are a One-Way Gamble
Sub : Eco
Sec: Fiscal Policy
Context: Union Budget & recent Tax Cuts
- The latest Union Budget has introduced significant income tax cuts, largely benefiting the middle class (2-3% of the population).
- Key changes:
- Tax-free income limit raised from ₹7 lakh to ₹12 lakh.
- Exemption limit raised for high earners (₹12L+) from ₹3 lakh to ₹4 lakh.
- Marginal tax rates reduced across slabs.
- Estimated revenue loss: ₹1 lakh crore (~8% of direct tax collections).
Two (2) Scenarios and their implications
Assumption by Government: Higher Income Growth Will Cover the Shortfall
- Despite reducing tax rates by 8%, the Budget projects a 14% increase in direct tax collections.
- To achieve this, incomes need to grow by 24%, which is over twice the nominal GDP growth (10.1%).
- Possible ways:
- Rapid rise in the number of high-income taxpayers.
- Higher tax buoyancy, meaning an increase in tax collections despite lower rates.
The Risk: What If Incomes don’t grow as expected?
- Worst-case scenario: If tax revenue falls short, government spending will have to be cut.
- Since under Fiscal Responsibility and Budget Management (FRBM) Act restricts government spending beyond tax revenue, making fiscal policy pro-cyclical (reinforcing economic cycles) rather than counter-cyclical (stabilizing them).
- Budget Deficit Targets:
- 2024 Revised Estimate: 4.8%
- 2025 Budget Estimate: 4.4%
- A lower deficit target means less flexibility to increase spending during economic slowdowns.
Will this strategy work?
- If the gamble works: Higher income growth → more tax collections → fiscal stability.
- If it fails: Lower revenues → budget cuts → economic slowdown → further revenue loss.
- Criticism: Relying solely on tax cuts to drive economic recovery is risky, especially when corporate investment remains weak.
Risk and Concerns
- Past budget trends show that when tax revenues fall, the government reduces spending across key sectors.
- Even flagship schemes linked to the Prime Minister saw budget cuts in the Revised Estimates for 2024.
- The most affected: Welfare programs for the poor and disadvantaged.
Fiscal Consolidation or Contraction?
- The government is prioritizing deficit reduction over economic stimulus.
- Key concern: If 4.8% deficit couldn’t boost growth, how will 4.4% do so?
- In a slowdown, economies need stimulus (exports, corporate investment, or government spending).
- With exports weak and corporate investment uncertain, the government is banking on tax cuts alone to drive growth.
K-shaped growth
- K-shaped growth describes an uneven economic recovery, often observed after a recession or a major economic disruption.
- In a K-shaped recovery, some sectors or groups of people experience a strong rebound, moving upwards like the upper arm of the “K”. Meanwhile, other sectors or groups continue to struggle and decline, resembling the lower arm of the “K”.
- This type of recovery creates a widening gap between the winners and losers in the economy.
- Examples of K-shaped growth: During the COVID-19 pandemic, Technology companies and certain sectors thrived, while industries like tourism, hospitality, and small businesses struggled.