How RBI repo rate cut and income tax changes energise India’s growth story

Notably, the Union Budget 2025 complements this monetary easing through significant changes in personal income tax slabs across all income groups. The main aim behind these tax reforms is to:

— Accelerate GDP growth 

— Encourage inclusive development

— Invigorate private investments 

— Uplift household sentiments, and 

— Enhance the spending power of India’s rising middle class 

Of these, enhancing spending power seems to be the main focus of the proposed changes in personal income tax. This is a bold move as it entails a reduction in direct tax revenue of Rs 1 Lakh crore. The new income tax slabs in India under section 115BAC (New Tax Regime) are as follows:

— Income up to Rs. 3 lakh: Nil tax

— Income from Rs. 3 lakh to Rs. 7 lakh: 5% tax rate

— Income from Rs. 7 lakh to Rs. 10 lakh: 10% tax rate

— Income from Rs. 10 lakh to Rs. 12 lakh: 15% tax rate

— Income from Rs. 12 lakh to Rs. 15 lakh: 20% tax rate

— Income above Rs. 15 lakh: 30% tax rate

Through this dual approach of monetary easing and fiscal stimulus, the government aims to achieve three main objectives, i.e. 

— Reducing the fiscal deficit

— Maintaining the level of public expenditure

— Giving a tax bonanza to the middle class.

These policy measures reflect a coordinated strategy to boost demand and investment. 

Implications for consumers and government

Let’s begin by addressing the last point first- increasing the exemption limit – and understand its implications for both the consumer and the government. The impact of this policy, which puts more money in the hands of consumers by enhancing their disposable income, has its foundations in the ‘multiplier effect’, developed by Keynes’ student Richard Kahn. 

The ‘multiplier’ is one of the chief components of Keynesian counter-cyclical fiscal policy. The reasoning of the policy is that an initial injection, which could be due to a change in autonomous expenditure – spending that happens independently of current income levels such as tax cuts or government expenditures – can generate a larger overall increase in economic activity through a ripple effect. 

In this case, the tax bonanza for the middle class is expected to stimulate consumption through increased disposable income. According to the multiplier effect, one rupee spent on fiscal stimulus eventually creates more than one rupee in growth, as measured by GDP.

An economy’s aggregate demand (Y) – the total demand for goods and services – is the sum of four components: 

Consumption expenditure (C)

Investment expenditure (I)

Government purchases (G) 

Net exports (X-M)

This relationship is expressed as: Y = C + I + G + (X – M)

Any increase in demand must therefore come from one of these four components. In this case, the government by doubling the income tax exemption limit – and accepting a reduction of 1 lakh crore in revenue receipt – hopes to see a multiplier-driven rise in consumption. The expectation is that the revenue loss will be compensated by a growth of 5 lakh crore in national income through the operation of the consumption multiplier. This is a Keynesian approach to reviving demand through targeted fiscal stimulus, with consumption as the primary engine.

Keynesian consumption multiplier

The Keynesian consumption multiplier explains how an initial increase in spending can lead to a larger overall rise in national income. The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume (MPC). The MPC is the amount of money spent out of every extra rupee earned.

The MPC is a key component of the multiplier:

Consumption Multiplier = 1 / (1-MPC)

A higher MPC results in a larger multiplier, which in turn leads to a greater impact on a country’s GDP.

When tax rates decline, the disposable income – defined as total income minus direct income taxes – in the hands of the consumers increases. It is defined by the equation: 

YD (Disposable Income) = Y (Income) – T (Taxes)

Consumer spending (C) is a function of disposable income:

C = f(YD)

This in turn causes an increase in consumer expenditure. The spending by consumers becomes income for businesses that they then spend on equipment, worker wages, energy, materials purchased, services, taxes, and investor returns. Worker’s income can then be spent, and the cycle continues.

Keynes and his followers believed that individuals should save less and spend more, especially if the economy in question has not achieved its full potential output. The increased amount of consumption would lead to higher employment and economic growth.

Figure 1: Impact of an increase in aggregate demand on GDP.

In the figure above, AD is the initial demand curve, and Y₁ is the corresponding equilibrium income level. A tax reduction leads to an increase in consumption expenditure (AB in the above figure) and the aggregate demand curve shifts from AD to AD₁. The final equilibrium level is Y₄. This increase in income from Y₁ to Y₄ is greater than the initial increase from A to B (AB=BC) {The final increase is greater than the initial one due to the multiplier effect}. 

Tax cuts impact through Keynesian Multiplier

The former Chief Economic Advisor to the Government, Krishnamurthy V Subramanian, has stated that the loss of Rs 1 lakh crore to the exchequer resulting from the recent income tax cuts will be more than compensated by the projected growth of Rs 5 lakh crore in national income through the consumption multiplier. 

According to Subramanian, there would be a rise in the incomes of close to 3.1 crore taxpayers due to the measures proposed by the Finance Minister for the coming financial year. This would lead to an increase in consumption by 3.2% and result in an increment of 1.8% in the GDP. 

These figures are based on the assumption that the MPC of the tax payers who are the highest beneficiaries – those with annual incomes up to Rs. 12.75 lakhs – is around 0.7 to 0.8. However, actual figures indicate that the MPC might be closer to 0.5 (as some households may choose to save, repay debts, or service existing loans), leading to an increase of only Rs 2 lakh crore instead of the projected Rs 5 lakh crore. In that case, the corresponding GDP would have to be revised from the projected 1.8% to 0.6%. 

The above analysis is based on a core tenet of Keynesian economics: Changes in aggregate demand – whether anticipated or unanticipated – have their greatest short-run effect on real output and employment, not on prices. 

Keynesians believe that because prices are somewhat rigid in the short-run, fluctuations in any component of spending – Consumption (C), Investment (I), Government Spending (G), or Net Exports (X-M) – primarily affect output and employment levels. This may be one of the reasons behind the Finance Minister’s decision to stimulate demand through a tax cut.

However, there are many other factors that need to be considered in analysing the final impact on GDP such as – the MPC of the class of consumers whose income is being affected; whether they use their increase in incomes to save rather than consume; whether they use the income bonanza to repay their credit card bills and other outstanding loans. In view of these variables, the exact effect on GDP will become clear over time, as economic data for the year is collected and analysed.

Post Read Questions

Evaluate the intended economic impact of the income tax reforms introduced in Budget 2025. 

What is the repo rate, and how does a cut in the repo rate affect loan and deposit interest rates?

Proposed changes in personal income tax is a bold move as it entails a reduction in direct tax revenue of Rs 1 Lakh crore. But how according to Keynesian theory a reduction in income tax potentially leads to an increase in GDP. 

What is the Keynesian consumption multiplier, and how is it calculated? Define marginal propensity to consume (MPC). Why is it important in determining the multiplier effect?

To what extent do you think monetary and fiscal tools are effective in offsetting external shocks like global trade tensions?

(Meera Malhan and Aruna Rao are Professors in economics at Delhi University.)

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