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.