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Among the many solutions proposed to counter the ongoing economic slowdown, tax rate cut seems to the one that government has chosen to implement. The corporate income tax rate has already been cut. There have been the demands to cut personal income tax as well, and now a senior functionary from the government has hinted about the possibility of the same.

Those who argue for tax cuts to aid GDP growth, broadly provide following two arguments –

- A cut in corporate income tax rate leaves the companies with higher profit, which will be used for new investments, which will aid to the GDP growth. Or, low tax rate improves the profitability, hence will attract new investments.

- A cut in personal income tax rate cut will result in higher personal disposable income, which will lead to higher personal consumption and hence higher GDP growth

This article tries to explain that why above-mentioned arguments are wrong for the current situation in India, or in other words, why tax cuts are unlikely to help against the current economic slowdown.

First, let’s start with the corporate tax cut. While, it is true that lower tax will leave the businesses with higher fund, the assumption that merely having extra fund will lead to businesses investing in new projects is against the common business sense. Businesses make investment only when there is an expectation of profit. And for profit to be realised, goods/services produced have to be bought by the consumers. Simply put, a motorcycle or TV maker is not going to invest in building new plant merely because it has some extra fund. Companies will make investment in building new plant only if they expect that in future there will be enough buyers for the motorcycles or TVs they will produce. The report by RBI shows that the capacity utilisation has been hovering at 72 – 73% in last few years, meaning that current capacity for production is good enough to meet new demand. In presence of such excess capacity, arguing that extra fund will lead to companies making new investments doesn’t seem credible.

One related argument is that the new investments do not have to be aimed at domestic market only. Many manufacturing companies are leaving China either due to increasing costs, or due to the ramifications of US – China trade dispute. For such firms, tax cut can make India an attractive alternate as a base for export. Though the studies, which analyse the factors that influence the location of foreign investments, find that most important factors to influence FDI in developing countries are political and regulatory stability, domestic market, natural resources, efficient infrastructure, and skilled human capital. Tax policies matter but less than previous factors. Moreover, the current projection of global growth and international trade are even less optimistic than the growth projection of Indian economy. In such global environment, the claim of tax cut being able to attract enough export oriented firms to improve GDP growth seems more to come from optimism than any realistic economic projection.

Coming to the second argument about personal income tax, it is true that a tax cut in personal income will increase personal disposable income, which in turn will lead to higher consumption. Though, it will lead to higher GDP growth is not necessarily the case. One of the basic equations economics student learn is the following –

GDP = Consumption + Investment + Government Spending + Net Export

Looking only at this equation, it sounds straight forward that if consumption is to increase, this will lead to GDP growth. This line of argument, however, ignores a simple fact that taxes paid by the private sector provides the government revenue which is the basis for government spending. So, ceteris paribus, while a cut in income tax will lead to increase in private consumption, it will simultaneously also lead to fall in the government spending by the same amount. Hence the tax cut, in the short term, only shifts the spending from the government to the consumer, with overall effect on GDP being minimal.

In the medium to long term, though, tax cut can affect GDP because of the following reasons - people have two choices with their income – consumption or saving. Poor people spend larger proportion of their income on consumption than rich people. And, since one person’s spending is another person’s income, people who consume more as proportion of their income, generate more income for people in the subsequent economic process chain.

In more technical terms, both these facts are stated in economic literature as following –

- People with lower income has higher ‘propensity to consume’, and

- Higher ‘propensity to consume’ has higher income multiplier effect

At the very essence, personal income tax is a redistributive mechanism, which transfers money from higher income group to lower income groups; or in other words, from people with lower propensity to consume to people with higher propensity to consume. A tax cut, on the other hand moves the money in opposite direction.

Hence, a tax cut will ultimately result in a lower income multiplier, exactly opposite of what is needed to counter the current slowdown.

To sum up, the current economic slowdown is arising from the falling demand, both domestic and global. The government’s response of tax cut to improve the falling demand does not seem to agree with the basic lessons of economics.

The views expressed in this piece are those of the author, and don’t necessarily reflect the position of CBGA. You can reach Suraj Jaiswal at suraj@cbgaindia.org.