Why the budget must bring income tax relief this time around

Why the budget must bring income tax relief this time around

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It's often argued that tax cuts can stimulate the economy. If so, given India's weakening urban consumption, the question is whether the government should consider cutting personal income taxes in the forthcoming Union budget or reduce rates that affect everyone like the GST.

Just about 10%-15% of the population pay individual income taxes and so a reduction in income tax rates can directly influence only a seemingly small set of spenders. On the other hand, a consumption tax like the GST is borne by everyone and given high inflation, lower taxes will straightaway reduce the burden on all households.  

So, should Finance Minister Nirmala Sitharaman consider direct or indirect tax cuts?

The rationale for individual income tax cuts is pronounced looking at recent data from two key surveys -- the Household Consumption Expenditure Survey (HCES) 2023-24 and the Annual Survey of Unincorporated Sector Enterprises (ASUSE) 2023-24.

First, HCES data confirms what we have known all along. That all is not well for the salaried class. This is further corroborated by GST cess collections (that track discretionary spending), which slowed down in the past five months. They grew at a dismal 3% compared to the 8% overall GST growth, hinting at reduced spending on luxury items. Likewise, passenger vehicle sales also confirms weak consumer sentiment.

Put another way, the middle class is not just grappling with high taxes, but is also dealing with stagnating salary growth as shown in Chart 1 below.

Between FY16 and FY20, salaries in the private corporate sector grew at a healthy pace averaging 9% growth in real terms. Following a dip during the pandemic, there was a substantial recovery subsequently till 2022-23. Since National Accounts data for FY24 and FY25 is unavailable, data sourced from the RBI database for listed companies indicates a substantial slowdown in real growth of wages in FY24 and H1, FY25.

HCES data showed that the growth in consumption expenditure for the bottom 50% of the households in both rural and urban areas was about 15% in nominal terms, while there was barely any increase for the top 10%. But here's the thing. The increase among the bottom 50% households is perhaps due to income transfers and a rise in employment over the last two financial years.

In fact, the budgeted expenditure (transfers) for FY25 stood at a staggering Rs 2 lakh crore as against Rs 0.6 lakh crore a year before. With more states going into elections, it's expected to increase further and as a recent Axis Capital report suggested, consumption expenditure of the bottom four deciles can be bumped up anywhere between 5% and 45%, thanks to state transfers.

However, there's a growing tax burden among the upper middle class.

Between FY19-20 and FY22-23, the tax liability of individual tax filers shot up by almost 70% from Rs 4.1 lakh crore to Rs 6.8 lakh crore.

And despite claims of a growing tax filer base, the number of actual income taxpayers has dropped. In FY22-23, out of the 74 million income tax filers, 52 million declared zero taxable income, while for FY19-20, out of the 65 million that filed returns, only 29 million declared zero taxable income. In other words, the tax liability for every tax-paying citizen jumped almost three times in just three years, though it's unlikely that their incomes increased by the same proportion.

In FY23-24 and FY24-25, the personal income taxes would grow cumulatively by 50% compared to FY22-23, while the income growth would be between 15% and 20%. On an overall basis, personal tax-to-GDP ratio was 2.5% in FY19-20 and would increase to  almost 4% by FY25.

A glaring disparity

The middle class, often referred to as the backbone of India's economy, may then justifiably feel overlooked if the upcoming budget doesn't address their growing tax burden, especially in the post-pandemic context. This at a time when corporates have benefitted from a significant tax cut in September, 2019 when rates were slashed to 22% for existing firms and 15% for new manufacturing units. The move was supposed to spur investment and job creation, but is yet to yield dividends.

Disappointingly, corporate investment as a percentage of GDP has remained stagnant, with much of the gains from the tax cut directed towards deleveraging, shareholder returns or building reserves rather than driving fresh capital expenditure. In stark contrast, the middle class, with declining savings rates has seen no comparable relief.

Worse, individual business incomes could be taxed at rates as high as 43%, while corporate incomes are taxed at a flat 25%. The glaring disparity not only strains individual taxpayers, but also incentivises tax evasion. Rationalising these rates is necessary to ensure fairness.

Coming to the ASUSE survey, which provides information on the unorganised sector, data shows a 16% growth in gross-value added in the surveyed unorganised sectors as well as a 13% wage growth per hired worker. This is also corroborated by the RBI data showing credit growth of almost 20% to MSME sector in FY24.

With a normal monsoon, expectations of robust agricultural growth and appropriate implementation of the measures announced for MSMEs in the previous budget, the incomes of low-income households would improve further. In other words, the forthcoming budget should focus on boosting consumption of the top 10-15%, which will have trickle-down effects.

How the government can manage the numbers

A potential income tax cut won't be a burden to the exchequer, provided the government strikes a balance.

To compensate for lower tax revenues in the short-term, the government can retain the current capex spending. But a slight trend reversal via Internal Extra Budgetary Resources (IEBR) for government departments, and public sector units like railways can manage the short-term fiscal situation.

As can be seen in Chart 3, the trend of the past 10 years indicates a drastic reduction in IEBR (both in value terms and as percentage of GDP) in the post-pandemic period. IEBR used to contribute significantly to the overall capex till FY19-20,but was brought into the budget post-pandemic in FY22.

The IEBR (as percentage of GDP) is at its lowest levels in 15-20 years at 1.1% of GDP. For 10 years before the pandemic, it averaged 2.5% of GDP. So, some increase in IEBR can take care of the expenditure part in lieu of likely foregone tax revenue.

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