DO TAX CUTS REALLY BOOST THE ECONOMY?

Tax cuts are to fiscal policy what rate cuts are to monetary policy-both are tools to stimulate economic growth. This has been a bumper year for tax cuts: in February the Union Budget raised the exemption limit for income tax, and in August GST rates were cut across a swathe of goods and services.

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The former was pitched as a reward for the hardworking middle class and the latter as a structural reform, but both measures were aimed at stimulating growth through increased consumption.

Tax cuts contribute to growth through two channels. The income effect boosts consumption and investment by unlocking income. A cut in income tax payable directly increases disposable income; a drop in GST does the same by reducing the cost of goods and services purchased. The price effect boosts demand by increasing purchasing power: that's because a GST cut is expected to reduce MRPs (maximum retail prices) of affected items. Additionally, an across-the-board GST cut encourages consumers to upgrade to premium items.

That's the theory-but past episodes show that the impact of tax cuts on growth is mixed and depends on other factors, both internal and external.

1997: DREAM BUDGET

Consider the 1997-98 'Dream Budget', which ushered sweeping cuts in personal and corporate income taxes, abolished double taxation of dividends, reduced peak customs duty, and simplified excise duties. Fortunately, wage hikes awarded by the Fifth Pay Commission were also implemented during 1997-99.

The result was a reversal of the cyclical downturn that had bogged the economy since the end of 1996-97. More importantly, tax collections remained buoyant for a few years following this budget, thus allowing the government to fund its fiscal expansion without excessive borrowing.

2009: FISCAL STIMULUS