We can’t expect budget tax cuts to boost GDP growth all that much
Summary
- Tax-cut beneficiaries are a small group with a lower than average propensity to use extra income for consumption, while fiscal spending will slow down. The net effect on India’s economic growth would be tiny.
Ahead of the Union budget, there was a demand from various economic participants to stimulate consumption. The government delivered this in a balanced way by boosting the disposable income of individuals through tax cuts while keeping a tight leash on its fiscal deficit. No individual needs to pay any tax on their salary income up to ₹12 lakh per annum in 2025-26, up from ₹7 lakh in 2024-25. The tax outgo for richer individuals has also been cut. This will cost the exchequer ₹1 trillion, according to government estimates.
Two obvious questions arise. Will these tax changes be sufficient to create a virtuous cycle of private final consumption expenditure (PFCE)? What would be the likely boost to real GDP growth? With more money in the hands of individuals, their spending will surely increase. But there are several caveats to consider when we look at the impact of these changes on GDP growth.
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The positive impact of higher individual spending on GDP growth can be measured through the marginal propensity to consume (MPC). It measures incremental consumption out of additional disposable income. The higher the MPC, the greater the positive impact of a rise in disposable income on consumption. India’s household savings are about 25% of disposable income, implying that consumption takes up three-quarters of it. The MPC would logically be higher than 75% for low-income individuals and much lower for the country’s richest.
To estimate the likely MPC that’s relevant to the budget’s tax-cut boost, we must study who the potential beneficiaries of tax reduction are. Our calculations suggest that more than 85% of all tax benefits would accrue to individuals with an annual income above ₹10 lakh, which is about four times the national per capita income.
On average, individuals with an annual income between ₹10 lakh and ₹12 lakh would save about 5% of their income, making them the biggest beneficiaries. The MPC of this section is likely to be lower than the national level. While there is no way to put a number to this, let’s assume it is 10-20 percentage points lower than India’s average, meaning an MPC of 65%.
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Before we estimate the likely positive impact on private consumption, there are two more adjustments to consider.
First, it is highly likely that a part of the increase in disposable income would go towards the repayment of consumer debt. Household debt has risen from 35% of income a decade ago to about 52% now. Assuming that just 5-10% of the incremental disposable income (i.e. ₹5,000-10,000 crore) is used to repay debt, it would reduce the rise in disposable income to ₹90,000-95,000 crore.
Second, any PFCE surge would be partly offset by higher imports (which is why imports are deducted from the sum of consumption, investment and exports to arrive at GDP).
The import intensity of India’s PFCE has fallen over the past decade. Consumption-related imports (i.e., all imports excluding capital goods, mainly for re-exporting, gold and silver) account for about 20% of PFCE now, compared with 25-26% a decade ago.
In simple words, about a fifth of the rise in nominal PFCE could be offset by higher imports. Thus, the effective MPC could fall to 50-55% after adjusting for imports.
An MPC of 50-55% (or 0.5-0.55 as a fraction of 1) would mean a consumption multiplier of 2-2.2 times, using the formula [1/(1-MPC)]. A rise in disposable income of ₹90,000-95,000 crore (after adjusting for possible debt repayments) would thus result in additional consumption of about ₹2 trillion. With total PFCE expected at about ₹200 trillion in 2024-25, it would mean additional growth of 1 percentage point in India’s nominal PFCE. With PFCE at some 60% of nominal GDP, this would suggest an increase of about 0.6 percentage points in nominal GDP growth. With a GDP deflator of 1.8 times, it would imply a rise in real GDP growth of about 0.30-0.35 percentage points.
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The story is not over yet. Tax changes are effectively a redistribution of resources from the government to individuals. Importantly, the government chose to keep a tight lid on the fiscal deficit by curtailing its spending. So, higher PFCE growth will be offset by slower growth in fiscal spending.
The Centre’s total spending (revenue expenses plus capital expenditure minus interest payments, subsidies and loans and advances) accounts for 9-10% of nominal GDP. It is budgeted to grow 5.3% in 2025-26.
Without forgone tax revenue of ₹1 trillion, the government’s total spending could have increased by 8.6% next year. This means that slower fiscal spending may shave off about 0.30-0.35 percentage points (3.3 percentage points of growth forgone in total spending multiplied by 9-10% share in GDP) from India’s nominal GDP growth. This would result in a real-GDP-growth drag of around 0.2 percentage points.
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Overall, the positive impact of 0.30-0.35 percentage points of higher private consumption on real GDP growth would be offset by the negative impact of about 0.2 percentage points due to slower fiscal spending. The net positive impact of tax cuts on real GDP growth, therefore, would be only 0.1-0.2 percentage points in 2025-26.
Granted, the MPC of tax-cut beneficiaries may be higher or lower, the import intensity of incremental PFCE could be different, debt repayments might not materialize and fiscal-spending growth may turn out differently. Still, all said, the net boost of these tax cuts to real GDP growth would be negligible.
The author is senior group vice president, Motilal Oswal Financial Services and author of ‘The Eight Per Cent Solution’.
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