A Budget in search of the middle class: Tax cuts may not spur growth

Much to celebrate in this Budget, but don't assume tax cuts will spark a growth revival

It should be obvious that Budgets capable of pleasing everybody are rare. It does not seem possible to simultaneously cut taxes, reduce debt and the deficit, and also invest in growth-promoting sectors and infrastructure. It appears, however, that this is precisely what Finance Minister Nirmala Sitharaman has attempted in the Union Budget for 2025-26.

 

There must be a catch somewhere, but nobody has been able to point to one yet. Most likely we will discover over the course of the coming year which of these three generally incompatible aims has been shortchanged. Perhaps the amount set aside for growth-supporting capital expenditure will wind up being squeezed? The enormous jump in public capex over the last term of the government — from Rs 3 trillion in the 2019 Budget to over Rs 11 trillion in 2024 — may now have to stabilise, if at a higher level. This will only be a problem, however, if it turns out that disproportionate increases in capex of the sort seen between 2019 and 2024 are essential to keep growth above six per cent.

 

 

The Budget tacitly makes the case that growth does not need this constant juicing of capex, and can instead come through the revival of demand from the “middle class”. I would feel a spot more comfortable about this if we had a clearer idea of what the Indian middle class is. A decade and more ago, some foreign analysts used to say it was anyone with at least a two-wheeler. Surely, that can’t still be true? Let’s have a quick look at the figures: The Union transport minister told Parliament a couple of years ago that there were about 280 million two- and four-wheeled vehicles in the country, which slightly contradicts his ministry’s earlier estimate of 326 million registered vehicles in 2020. Take a little off that to get to a number for personal vehicles, because about one in five four-wheeled vehicles sold are commercial.

 

There’s another way of getting to similar numbers for the middle class. The Prime Minister, meanwhile, addressing an automotive summit recently, said that he had opened up for them a market of about 250 million — what he has long called the “neo-middle class”. That is perhaps a reasonable estimate of India’s real middle class. The old middle class — people who could afford a vehicle three decades ago — are perhaps best viewed as actually being the rich. There were between 50 and 60 million such vehicles on Indian roads two decades ago; put 250 million and 50 million together, and we arrive at a similar number.

 

But that is also approximately how many households there are in India; the Periodic Labour Force Survey put the number at 294 million in 2022-23, of which 206 million live in rural areas. The number of households with multiple vehicles is not generally supposed to be very large. So, is it the case that everyone in India is in the middle class now?

 

Surely not. One incontrovertible fact is that more than 800 million people — or about 60 per cent of India — receives free foodgrain under the Pradhan Mantri Garib Kalyan Anna Yojana. It’s hard to see this 60 per cent as being middle class; and so we have an upper limit for the middle class at 40 per cent of the country: 600 million people, fewer than 120 million households.

 

But that is not the middle class that we’re talking about today, surely. If we want to look at the number of people who would be interested in whether they are eligible for lower taxes under the new Budget, that would be a much smaller number. There were 75 million returns filed last year by the due date, of which almost 47 million paid nothing. About 27 million are thus affected by the news. Is the middle class the 30 million or so direct taxpayers? Or the 120 million households not dependent upon the government for food? Can a group of 30 million even be considered “middle class” if they are the richest segment of a country of 1.4 billion? That seems to stretch the definition of “middle” a bit too far.

 

We need to be able to answer that question cogently before we rely on some notional middle class to get us out of growth slumps. A revival in consumer demand led by the 30 million who currently pay taxes is going to look very different from the one led by the much larger number who don’t qualify for free food. It will require very different policies, and spark off very different investments in supply capacity to meet additional consumer demand. The two different kinds of growth revival will also have varying levels of sustainability over time. The less broad-based one is likely to burn brightly but sputter out sooner.

 

Tax relief is justifiable if it is introduced for moral reasons — taxpayers pay too much for services that are too poor, for example. It can also be explained away if it simplifies or rationalises procedures, or extends and expands the tax net. But as a growth-supporting mechanism, we must recognise that its consequences are hard to predict, especially when we can’t even properly define the target of our measures.

 

Some recent history might be relevant. As Suranjali Tandon of NIPFP has pointed out, the corporate tax cut of 2019, which cannot be faulted for ambition, led to income foregone, according to a Parliamentary committee, of Rs 1.85 trillion. This improved corporate health and allowed companies to hold on to some cash, or manage debt during the pandemic years. But only 0.1 per cent of companies reported new investments under the special lower tax rate of 15 per cent. While Covid-19 might have a role to play in explaining this underwhelming number, it nevertheless stands as a recent testament that tax cuts can rarely be justified as an effective form of growth promotion. The behavioural and distributional impacts often get in the way. Long-term studies in the US, including by Brookings, have found “little evidence that tax cuts or tax reform since 1980 have impacted the long-term growth rate significantly.”

 

By all means, let us celebrate a Budget that gestures towards deregulation, increases economic openness, and promises reform of direct taxes. There’s a lot here to be pleased about. But we should not get carried away and assume that “middle class” tax cuts are what were delivered, or that what we got will necessarily restore growth momentum to the economy. The disproportionate attention and approval these cuts have received suggests that my own private definition of the Indian middle class is perhaps the most useful: The middle class is that group of Indians who dominate narrative-building so completely that the government must address their interests even when nothing else is working.

 

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The author is director, Centre for the Economy and Growth, Observer Research Foundation, New Delhi