TAX CUTS CAN BOOST GDP.WHAT IF IT DOESN'T PAN OUT?

Weak economic growth could lead to distress and a greater need for social spending

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When finance minister Nirmala Sitharaman announced tax cuts and sops for taxpayers in her latest budget, she said: "Slabs and rates are being changed across the board to benefit all tax-payers. The new structure will substantially reduce the taxes of the middle class and leave more money in their hands, boosting household consumption, savings and investment." Changes included pushing forward the starting point of income tax from an annual income of 7 lakh to 12 lakh, and a revision in tax slabs.

The government can boost consumption in the economy in two ways. The first, and more direct, method is for the government to itself spend more, on areas like infrastructure, or social programmes like the rural-employment programme. The second, more indirect, way is to do what the government did: cut taxes, leave more money in the hands of consumers, and hope that they spend that extra money.

Spending on an infrastructure project, for example, leads to jobs being created. Workers on such a project add to the overall size of the consumption spend in the economy with the income they earn. Consumer spending out of new earnings, or through tax cuts, add to the bottom line of the corporate sector, making it more willing to invest in new plants and machinery, and to hire more workers. Thus, a virtuous cycle of spending is created, which creates more jobs, which creates even more spending, and so on.

The finance minister is only the latest in a long line of ministers, both in India and abroad, who hope that cutting taxes will stimulate consumption-and, by extension, growth.

Of the two options, it's clear the government, for now at least, has chosen the second one. As Mint pointed out in a recent article, beyond the headline-grabbing tax cuts, the government budget has reduced the size of the budget this year relative to GDP in its attempt to meet earlier promises of a reduction in the fiscal deficit.