Relaxation in Tax Slab- A Masterstroke or Economic Absurdity
Posted in Finance Articles, Total Reads: 4912
, Published on 22 September 2014
Since the year of liberalisation, India is experiencing one of its worst economic slowdowns. The growth of the economy has been erratic thanks to a depreciating currency and high inflation rates, with frequent blemishes on the reputation of the country thanks to various scams like the Colgate Scam and the 2G fiasco. All these have just led to an ever declining confidence of the foreign investors in the economy of the largest democracy of the world… Indian economy awaited a transformation.
Image Courtesy: freedigitalphotos.net, Stuart Miles
The GDP growth rate of India can be explained using the following graph:
A lot of hue and cry was raised over the last couple of months with regards to the new NDA Government and its much hyped pro industry Union Budget. The Government had two objectives:
• Stimulate savings in the economy, and
• Reduce the Government Deficit to 4.1% of GDP for FY 2014-15
The individual tax payers had expected the minimum tax exemption to be raised from Rs. 200,000 to Rs. 300,000 without altering the tax brackets. However, the possible inflationary pressure forced the Government to increase the limit by only Rs. 50,000. The measure would, undoubtedly, boost the individual savings of the people of the country but in order to understand the impact of the same on the national savings, a detailed analysis needs to be undertaken.
According to a research conducted by the Economic Times, in a population of 1.2 billion, only 2.9% people pay tax in India, i.e., there are only 35 million tax payers in the country. As previously mentioned, the Union Government has increased the minimum the minimum basic tax exemption limit to Rs. 250,000 from Rs. 200,000. The result of this measure is that from the Assessment Year 2015-16, people in the tax bracket of Rs. 250,000 to Rs. 500,000 shall be taxed at 10%, proving them with an increased savings of Rs. 5,150.
Current Year's Exemption Limit (A)
Last year's Exemption Limit (B)
Exemption Benefit (A-B)
Tax Rate (C)
Sum of education cess and secondary and higher education cess (D)
The increase in private savings have come at a cost to the public savings. As a result of the introduction of this measure the Government of India stands to lose Rs. 18,025 crores (35 million tax payers * Rs. 5,150 tax saving per individual) in the FY 2014-15. The attempt in this analysis is to study the loss of Government revenue, merely from the increase in the exemption limit. This loss would only increase, if other measures introduced by the Government to boost the private savings are accounted for.
The purpose of this measure was to increase the private savings by reducing the income tax burden on the individuals. Under ideal circumstances, increase in savings brings about an equivalent increase in the investments. Therefore, it was anticipated that increase in savings would lead to an increase in investments.
According to the National Income Identity,
Y = C + I + G
Y = National Income
C = Consumption Expenditure
I = Investment Expenditure
G = Government Expenditure
(Y – T – C) + (T-G) = I
Or, Private Savings + Public Savings = Investment
Thus, on one hand, the private savings would increase by Rs. 18,000 crores which would be nullified against the decline in the public savings by an equivalent amount, bringing no absolute change in the national savings. Hence, it can be concluded that the relaxation of the tax slabs would not bring about any change in the savings or investments in the economy.
According to CMIE report, June 2014, which, the fiscal deficit of India during the FY 2013-14 was Rs. 508,000 crores, which corresponds to 4.5% of the GDP of the country. The total expenditure of the Government was Rs. 1,560,000 crores. The tax revenue was sufficient to fund 74% of these expenditure. What is important to note here is that the income tax collection targets had fallen short by approximately Rs. 10,000 crores.
In the current budget, Arun Jaitley, the Finance Minister has set the target to reduce the fiscal deficit to 4.1%, increase the tax collections target to 1,364,000 crores. The expenditure of the Government is expected to shoot to 1,800,000 crores.
The budget deficit of the Indian Government over the last decade is presented as under:
Based on the above data and the loss of revenue of Rs. 18,000, the following conclusions may be drawn:
• The proposed revenue of the Government could have been higher by 1.46% (20,000 crores / 1,364,000 crores)
• The Government could have financed 1.11% (20,000 crores / 1,800,000 crores) of the proposed expenditure for FY 2014-15 by the amount lost to tax slab relaxation
The World Bank estimates the Indian economy to grow by 6% in the current fiscal year. Thus, the GDP of the country is expected to grow from USD 1.87 trillion to USD 1.98 trillion in FY 2014-15. Even if assume that the Indian Government would be able to achieve the set target of 4.1% of fiscal deficit (which is nearly impossible), it would still be short by Rs. 480,000 crores. The 18,000 crores loss of revenue id bound to pinch in this scenario. Also, important to note here is that with Rs. 18,000 crores, the fiscal deficit could have reduced to further 3.9%. This 0.2% decrease could have certainly provided some comfort to the Government, especially, when your economy is developing. A higher fiscal deficit means higher debt servicing costs, reduced expenditure in areas like education and infrastructure. A higher public borrowing can also lead to the crowding out of private investments, reducing the growth of both human and physical capital.
However, it would be incorrect to conclude at this juncture that the relaxation in the tax slab was not beneficial to the economy at all. One must, consider the impact of aggregating the private savings of Rs. 5,150/individual on the economy as well.
As per the Accenture Survey in 2012, an average Indian is conservative as far as his income is concerned and on an average saves 39% of his income annually. This implies that with an increase in disposable income by Rs. 5,150, an approximate private savings would actually be Rs. 2,000.
At this juncture, one must analyse the significance of this Rs. 2,000 into the Indian economy.
Although, it has been proved that increase in private savings shall be offset by a decrease in public savings, realistically speaking, the Government stands to earn a lot more as a result of this measure. The multiplier effect would cause the savings to multiply at each stage, providing an opportunity to the Government to impose tax at every such stage, as explained in the diagram above.
For instance, the savings of Rs. 2,000 is invested in a fixed deposit, paying 6%p.a. The taxable income for the individual in the following year would be higher by Rs. 120; the total income in the economy rising to 420 crores. Assuming, a net interest margin of the bank to be 3.5%, the profit for the bank would be Rs. 70; Rs. 245 crores when computed for the whole population. This (420 crores and 245 crores) would be taxed by the Government at 10% for individuals and at 30% corporate tax for the banks, increasing Government revenue by Rs. 70 crores.
Fixed Deposit (A)
Interest Rate (B)
Total Tax Payers (C)
Taxable Income Increase (D=A*B*C)
Average Net Interest Margin of a bank (E)
Profit of Commercial Banks (F=A*C*E)
Income Tax Rate (G)
Corporate Tax Rate (H)
Government Earning (I=(G*D)+(H*F))
The tax collection for the Government, in fact, would be even more if one considers the salaries of the bank employees and a corresponding income tax rate is applied to it. Also, the banks would have more money to lend to the corporates, who would use the funds to invest and increase the future capacity of their organisations.
Even for the increased consumption of Rs. 3,150 per individual, the Government would enjoy the revenues accruing from taxes on consumption like Service Tax and Import Duties. Also, the increased taxable income means increased purchasing power, which in turn means an increased demand of goods. This provides great opportunity to the marketers, especially the FMCG sector. The Government once again would enjoy increased revenue by taxing the FMCG sector.
Now, that both the sides of the coin have been analysed, it would be difficult to actually conclude if the move of the Government was good or not. However, I feel, that for a developing economy like India, where a large proportion of the population belongs to the middle income group, such a measure would enable the population to better tackle inflation and price hike. Capitalism, too, would be promoted as a result of increase in private savings. But, it is only for the Time to say, whether the “achhe din” is actually around the corner or not.
This article has been authored by Saket Hawelia from IIM Shillong