FEBRUARY 10, 2025

By K Srinivasan

WHETHER increase of income by way of enhanced tax exemptions, will necessarily result in increase in consumption and in turn increase in GDP and creation of additional employment, as envisioned in the budget proposals?

Consumption is an important component used in the measurement of GDP. Determinants of consumption includes income, savings, expectations, changes in fiscal policy and availability of goods and services.

The Government has been mulling over the idea for some time now, of putting in the hands of general public greater amounts of disposable income to spur the consumption function so as to maximize GDP and employment creation.

The recent budget witnessed an increased amount of standard deductions, resulting in NIL tax up to an income of Rupees 12 Lakhs. Tax is chargeable @15% between 8 Lakhs and 12 Lakhs and standard deductions are increased to 60,000/- so that the net tax is 'NIL' up to an income of 12 Lakhs effective for the financial year 2025-26.

This tangibly places at the disposal of the middleclass households and Senior citizens a sizeable sum of at least 60,000/- to 70,000/- rupees in a year, of which a major portion is expected to be spent on consumption and the remaining, saved.

Such increased availability of disposable income normally spurs consumption and which results in a direct increase in GDP, is the common belief and the general theory of economics.

But then, all of the said increase in income need not necessarily result in consumption as a portion of it may be routed towards savings, for reduction of personal debt and so on. This is called the 'Permanent Income Hypothesis' of Milton Freidman.

This theory implies that policies aiming to boost consumption and GDP through short term income increase might not be as effective as anticipated.

Keynesian theory is also that marginal propensity to consume (MPC) which is said to be a consumption function shifts forward or upward, when disposable income also increases. The inverse is true of a downward shift in the consumption function.

Keynes believed that individuals should save less and spend more, raising their marginal propensity to consume (MPC) to effect full employment and economic growth, which is also the fond expectation of the Government by the increased income tax deductions to make available increased disposable income in the hands of the people through the 2025 budget proposals.

Following the aspirations to leverage behavioral insights based on Thaler's Nudge theory, NITI Aayog has advertised for setting up of a 'Nudge Unit'.

In an attempt to nudge citizens to change their behavior, policy makers are being nudged into falling prey to the very problems that they aim to solve.

The recent emphasis on behavioral economics and nudge theory by expecting tax cuts to improve consumption/reduce inflation and increase GDP is a 'decoy' and is seen as an attempt to climb onto the popular bandwagon, and has no real clarity in policy design.

The MPC is only a fraction of additional income that is spent on consumption and according to Keynes it is always less than '1' but greater than 'Zero'.

Let's hope that the recent B-(n)udge-T changes of 2025 of 'NIL' income tax up to 12 Lakhs income really prompts people to consume more goods and services and thereby levels of inflation is sought to be addressed and GDP improved and employment created, even if less than one but greater than Zero, it will still be well worth the Government's effort.

[The author was formerly with Indian Revenue Service and is now a senior Associate, RANK Associates, Chennai. The views expressed are strictly personal.]