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Why a tax cut might not be the best idea

The post is written by our EZPP partner Chhavi Chadha with relevant edits and changes by our editorial team. We routinely partner with high-quality industry professionals to develop content for our platform. If you're interested in joining the program, please apply here: EZPP

Budget FY21 is possibly one of the most awaited events to start this new decade and a pivotal one at that. In an economy that seems to be heading south, one of the many solutions that had emerged was a tax break for the income taxpayers, which may provide some relief and present hope of reviving demand. With the central bank reaching the end of the rope, the expectations of a fiscal stimulus increased further. In today's post, we discuss why tax cuts don't always translate to greater spending, the bandwidth the government has to allow for such a cut, and potential ways the government could work around the issues.

Do tax cuts always spur consumer spend?

While theoretically, it might seem direct tax cut could spur the demand in the short term, this doesn't always manifest. In times of economic stress, like we are seeing today, the average person tends to be risk-averse and is generally thinking about protecting their 'rainy day fund'. The tax cut in such a scenario will often translate to increased saving instead of growth in consumption. It also helps to look at the level of tax compliance and the average profile of the taxpayer in the country. With compliance still south of 5%, and the average tax payer tends to be a small chunk of middle/upper-middle class population - a segment that is generally not too material from an electoral standpoint; especially with options open to deploy the funds lower down the economic strata, where both electoral gains and impact on consumer spending would be much larger.

Does the government have the bandwidth for a tax cut?

It helps to understand the background in which the budget is being made. We have recently had a corporate tax cut dropping the rates from 30% to 25% that has already put significant strain on the fiscal deficit. The economic slowdown has also translated to lower direct as well as indirect tax collections driven by unemployment, wage stagnation, and controlled spend. Indirect tax slippages haven't been completely plugged yet limiting the benefit the government could hope to capture from the increased spending.

A tax cut now will come at a cost - a significant hit to the fiscal deficit number, something that international rating agencies will be watching closely. An impact on the country's sovereign rating or risk profile in general makes capital costlier across the board, which has further negative implications on growth. While the government can always fall back on divesting key assets away, it has already begun to see attacks around "selling the family silver" by members of its own party, that could put potential caps or delays on divestments. The combination of these factors lead us to believe that the government has extremely limited bandwidth to execute the cut.

Could there be workarounds?

It also helps to understand that the BJP government has been consistently losing support at the state levels, losing state elections leading upto the central elections, as well as losing footing in traditional strongholds after the central elections. It will therefore be keen to take steps to reduce some pain and discontent in the system. While a secular tax cut might not be on the cards, it might consider moving around tax slabs, or combining a tax cut with cut in exemptions to reduce fiscal stress of the move. Any move will have to be thought through well though, because such moves are traditionally a lot harder to roll back, and it's still in year 1 of its 5-year term.

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