Budget should cut direct taxes, boost spending

Amarendu Nandy/Abhisek Sur | Updated on February 01, 2020

The Direct Tax Code should be implemented to spur consumption, with investment not picking up

It is going to be an incredibly tough balancing act for Finance Minister Nirmala Sitharaman, as she presents her second Budget against the backdrop of a plunging economy. There are challenges galore, both on the domestic and external front.

As estimated by the Economic Survey 2019-20, output growth is likely to hit a decadal-low of 5 per cent this fiscal, and it shall be an arduous task to attain the growth target of 6-6.5 per cent in the next fiscal. Gross fixed capital formation as a share of the GDP has been steadily falling, and at 28.1 per cent in FY20, the share has fallen by over 6 percentage points in the last eight years. Further, as the advance estimates released by the government earlier this month suggest, investment growth at just 1 per cent is going to be the slowest in 17 years. Several attempts to boost growth via the investment channel, through fiscal and monetary measures, has unfortunately not yielded the desired results.

Similarly, private consumption growth at 5.8 per cent, manufacturing growth at 2 per cent, and agricultural growth at 2.8 per cent are going to touch the lowest rates in the past seven, 15 and four years, respectively. On the other hand, headline inflation at 7.35 per cent in December 2019 (highest since July 2014) has already breached the upper band of the RBI’s inflation target. The unemployment rate has soared to an all-time high of 8.5 per cent in October 2019. India’s lack of export competitiveness has resulted in stagnant export earnings at around $300 billion, since 2011-12. Overall, the macroeconomic numbers portend a grim economic scenario indeed.

Growth strategy

In the past year, the government’s explicit focus has been to pursue an investment-led virtuous cycle of growth — a strategy vigorously advocated in the Economic Survey 2018-19. Clearly, the strategy does not appear to have had any impact, despite complementary fiscal and monetary policies, which slashed the effective corporate tax rates and reduced the repo rates by 135 basis points in less than a year’s time.

There has been a clear lack of policy focus on boosting private consumption. While consumption is the more stable component of aggregate demand, arguably due to the consumption smoothing behaviour of the households, a sharp decline in household financial savings in the past several years has meant that such smoothing behaviour through dissaving has not really worked.

Despite the fact that there is lack of fiscal headroom to pursue expansionary fiscal policies, it is but the best bet at this juncture. To drive aggregate demand and growth, fiscal expansionary policies should aim to stimulate a consumption-driven multiplier process. This will, in turn, mean not only more employment (and income) generation, but also finding ways and means to boost disposable income of the largest segment of the economy — the households. This can be achieved by enacting direct tax reforms, particularly implementing the proposals on personal income taxes as advocated in the Direct Tax Code (DTC).

Structural tax reform

Although the recommendations of the Akhilesh Ranjan Task Force on the DTC (which submitted its report in September 2019) is yet to be made public, various reports suggest that the committee has rightly proposed rationalisation of the income tax rates and structure. Such rationalisation can not only prove to be instrumental in reviving private consumption and growth, but will also go a long way to make the overall tax structure less regressive.

Consumers’ expectations on the economic environment and incomes, as indicated in the Consumer Confidence Survey data released by the RBI in October 2019, continue to remain less optimistic. In this scenario, structural tax reforms are likely to have a more robust and long-term impact as opposed to some ad-hoc changes in the tax rates or exemptions. The perception of tax cuts, being temporary, might boost savings rather than consumption and lead to low fiscal multiplier.

Direct tax reforms are in limbo, primarily on the argument that it will adversely affect the government exchequer. It is advisable to bear the pinch in the short run for long-term gains, particularly when the government has already breached the FRBM targets. The rationalisation of the tax rates, on the contrary, could lead to better tax compliance.

High marginal tax rates could lead to a rise in the dead-weight loss to the economy, and as the rate gets close to the revenue-maximising point, the loss to the economy exceeds the gain in revenue. Therefore, it is imperative that policymakers should strive to set tax rates at the growth-maximising point.

Nandy teaches at IIM-Ranchi. Sur is a researcher at Jindal Global Law School

Published on February 01, 2020

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