An income-tax cut instead of a corporate tax cut in 2019 would have done more for the economy
After a heavy focus on public capex in the last three-four years, the government has opted to add an income-tax cut to boost consumption and growth. Capex spending remains elevated but has plateaued. Of the budgeted capex, substantial allocations are for new projects in Bihar, given the upcoming state elections there. The rest is largely to complete projects already underway. The government now hopes that a substantial tax cut for the middle class will boost consumption and eventually help revive private investment.
What is proposed is a tax cut of around Rs 1 trillion (0.3 per cent of gross domestic product), but for a relatively small population of about 47 million urban taxpayers. Assuming a propensity to consume of 0.8, the tax cut will have a lower multiplier effect than direct government spending. And if some of it spills over into higher demand for supply-constrained food items, will it also increase inflation and complicate monetary policy further?
My research at National Institute of Public Finance and Policy showed that corporate investment is primarily driven by capacity utilisation, competitiveness, and credit availability. Capex spending has a bigger effect on non-corporate investment — especially in housing and retail. Therefore, if the objective is to boost corporate investment, the shift from relying solely on capex spending to also include tax cuts to boost consumption and, thereby, enhance capacity utilisation is worth a try.
Despite record corporate profits in FY24—with the profit-to-GDP ratio for Nifty 500 companies rising to 4.6 per cent, the highest since FY08—private investment has not picked up. These record profits have largely come from cutting labour costs rather than higher capacity utilisation through sales. Nominal sales of the corporate sector grew by just 6 per cent.
Ironically, the corporate tax cut of 2019 cost the government Rs 7-8 trillion over the past five years. The corporate sector invested very little of its tax bonanza. In hindsight, a middle-class income tax cut in 2019 might have done more to boost the economy—and even corporate investment—than a corporate tax cut.
The Economic Survey also attributes low private investment to an over-regulated economy and advocates a trust-based regulatory system—“innocent unless proven guilty” rather than the other way around. The Budget proposes yet another committee to draft a deregulation plan — we could call it the Special Committee on Regulatory Efficiency (SCORE), given this government’s fondness for catchy acronyms.
However, while a regulatory clean-up is needed, it will not bear quick results. To show seriousness, the Budget could have announced a few deregulatory measures immediately. The focus on understanding why private sector research & development (R&D) in India remains low is a welcome step. As I highlighted in my February 2024 column, “India’s Research Riddle”, India has one of the highest shares of public R&D spending as a percentage of GDP but one of the lowest for the private sector. I was pleased to see the 2024 Economic Survey examine this issue in detail, and the Budget introduce incentives to encourage greater private sector R&D investment.
Getting more value from public R&D spending, which sits in siloed public institutes with limited interactions with universities and the private sector, is also needed. The government’s effort to set up an R&D fund is meant to encourage this interaction.
In agriculture, broader reform is needed, but for now, focusing on boosting the production of commodities like fruit, vegetables, and pulses—where supply constraints have made the fight against inflation difficult—is welcome. Building infrastructure to boost tourism and tap into India’s hugely underutilised tourism potential is also a positive shift. The focus on religious tourism will attract both international and local tourists and boost the economy. Medical tourism is another focus in the Budget, with visa relaxations as well as the development of 50 tourism sites in collaboration with state governments.
Also welcome is the calibrated reduction in import tariffs on some final products like motorcycles—which Donald Trump focused on in his first term—as well as intermediate products in key industries like smartphones, pharmaceuticals, and EV batteries. This should help correct the inverted duty structure that has hurt India’s competitiveness. More reductions may follow to ward off a Trump tariff threat in February when the Prime Minister visits the US.
What is disappointing is defence spending. Given rising geopolitical fragmentation, India is neither spending enough nor allocating funds wisely. With pensions and wages consuming almost three-quarters of the defence budget, there is only a slight increase in capital outlays and equipment. As the Ukraine war shows, the nature of modern warfare has changed significantly—it’s not bodies but modern equipment that matters. However, this requires a broader restructuring, followed by budgetary decisions to support it.
Finally, most analysts are happy with the decline in the projected fiscal deficit to 4.4 per cent of GDP in FY26. But at that level, it is still well above any pre-Covid budget deficit of the Modi government. India’s public debt as a share of GDP started rising after FY15, despite a period of favourable external factors, and currently sits at 84.3 per cent of GDP. Debt repayment and interest payments make up almost a quarter of the government spending, crowding out other spending, and there is limited headroom if another crisis hits. It’s now time to bring the consolidated public debt level down to at least 70 per cent of GDP more rapidly than projected in the Budget. Aggressive divestment is the only way to be able to do that, with about Rs 35-40 trillion of non-strategic assets that can be sold.
Middle-class tax relief is welcome and will be extremely popular. But whether what is proposed is sufficient to move the needle on India’s growth trajectory remains to be seen. For that, the factor reforms — especially labour laws and land acquisition — promised in the run-up to the general elections, working with states, are badly needed.
The author is distinguished visiting scholar, Institute for International Economic Policy, George Washington University
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