Income-tax break unlikely to boost consumption: Ex-IMF India Rep

Union Budget 2025-26, touted as a middle-class bonanza with significant tax cuts, faces scrutiny from economic experts on its ability to drive sustainable growth. In an interview with The Federal, Josh Felman, former IMF India Representative, weighs in on India’s fiscal strategy, the potential impact of income-tax cuts and the challenges in achieving the government’s growth targets.

While acknowledging fiscal stability, Felman raises concerns about the broader economic outlook, questioning whether the current measures are enough to spark the robust growth India needs. He also wants India to cut reliance on the US to mitigate tariff risks. Edited excerpts:

How will you read the Indian budget for 2025, which includes significant income-tax cuts and is being framed as one designed to benefit the middle class?

I agree that this budget is indeed tailored for the middle class. However, it's essential to evaluate it based on a more comprehensive set of criteria. First, what measures does it take to ensure macroeconomic stability? Second, how does it foster growth?

Both of these factors are crucial — while stability is necessary, growth is equally important for the long-term health of the economy. So, rather than relying on the typical analysis of being 'a budget for the middle class', I would suggest assessing it against these two critical dimensions.

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Will the Rs 1 lakh-crore tax break for 1 crore taxpayers immediately boost consumption or will it be a while before its impact is felt? Also, what kind of multiplier effect do you anticipate from this move, given the potentially overstated revenue targets and steady expenditure projections?

The honest answer is that we don't really know for sure. My guess is that much of this tax cut will likely be saved rather than spent. If you look at other countries that have implemented tax cuts, it's often the case that the tax relief ends up being saved instead of being spent.

Furthermore, they hear that the economy is slowing down, which adds to their apprehension. And of course, there's also the concern about job security, with stories of layoffs and unemployment floating around. After weighing all this, many middle-class households may conclude that now might not be the right time to increase spending. I suspect this kind of cautious thinking will be widespread among middle-class families.

Looking at the budget from a macro stability perspective, the fiscal deficit has been kept on target at 4.8 per cent, with next year's projection at 4.4 per cent of GDP, indicating progress on the fiscal consolidation path as promised under the FRBM Act. Additionally, the budget outlines a Rs 14.8 trillion borrowing plan, which should provide sufficient liquidity for lending. With a focus on boosting consumption, the government hopes that the Rs 1 lakh-crore tax cut for the middle class will help revive the economy, potentially unlocking Rs 60,000-70,000 crore in spending. Do you think these steps are sufficient or do you believe the fiscal stability and the broader measures may fall short in driving the desired economic recovery?

It's certainly a positive that the government has managed to reduce the budget deficit, as you pointed out, both this fiscal year and in the projections for the next. It has demonstrated remarkable determination to meet its budget deficit targets, particularly outside of the pandemic period when the usual constraints were more relaxed.

In most years, they've tended to hit these targets by setting relatively conservative revenue forecasts, which, when exceeded, make it easier to meet, or even outperform, the deficit target.

This year, however, I noticed a shift — revenue targets, particularly for personal income tax, seem more ambitious. The forecast for personal income tax is set to grow by 14.4 per cent, significantly higher than the nominal GDP growth of 10 per cent. While it's true that income tax has outpaced GDP growth in previous years, much of that growth was driven by capital gains tax, which is difficult to replicate given the uncertainty in the stock market. It seems more likely that income growth will be driven by wages and salaries, which typically grow at a rate closer to GDP.

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On top of this, the budget includes a tax cut, which further complicates the picture for rapid growth in personal income tax receipts. There's also an optimistic outlook on corporate income tax. While I don't see a significant risk of the budget deficit being missed, there's a possibility that achieving these targets could result in expenditure compression.

And the only area where they could realistically reduce spending is in capital expenditure (capex). This raises a concern as there's no substantial increase in capex in this budget. If the revenue falls short, there’s a real risk that capex could decline, which could dampen growth prospects.

Based on what you've said, it seems that we can only speculate at this point about the impact of these tax cuts. If we consider that previous corporate tax cuts haven't led to the expected boost in investment — perhaps due to excess capacity — where do you see the economy heading in this context?

The key number I want to emphasise is 4.8. This isn't about the budget deficit but rather about India's economic growth since 2019, which has averaged at just 4.8 per cent. This figure raises an important question: What is the true potential growth rate of the Indian economy? If it's around 8-10 per cent, recent slowdowns may be just a temporary lull. However, if the potential growth rate is closer to 5 per cent, as recent trends suggest, the country may need deep structural reforms to achieve the 8-10 per cent growth we've hoped for.

Under Modi 1.0, the strategy was to implement structural reforms and clamp down on corruption, expecting this to fuel growth. But it didn’t work. With Modi 2.0, the government adopted what I call the "China strategy," focusing on building infrastructure and offering incentives to attract firms, like the PLI (Production Linked Incentive) scheme to promote manufacturing in India. Despite these efforts, growth has remained stagnant at around 5 per cent over the past five years.

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Looking at the latest budget, it’s unclear what growth strategy Modi 3.0 is pursuing. There are three potential options: (1) continuing with the existing strategy, asking for more time to see results; (2) accelerating infrastructure spending and the PLI scheme; or (3) introducing a new approach altogether.

The budget doesn’t seem to lean toward option 2 as there is no major infrastructure push or significant mention of PLI. As for option 3, while there are hints of deregulation, it’s unclear whether this will be a meaningful change or just another committee making plans with no action, much like the past disinvestment committee.

It seems like a mix of a "wait and see" approach with some deregulation hints could be the strategy, especially amid global uncertainty and volatility like the Trump tariffs. Do you think this cautious blend is the right move, or could it lead to missed opportunities for stronger action?

You raise a great point. Honestly, it seems like Modi 3.0 is still in a "wait and see" mode, which aligns mostly with option 1. The government might be hoping the economy picks up on its own — perhaps the tax cuts will boost consumer spending or maybe the potential growth rate is really 8 per cent, and things will improve naturally. In the meantime, they could be studying deregulation to have it ready if needed.

You've also brought up a key point about the external environment becoming more volatile, especially with the arrival of Trump. In response, the government needs contingency plans. If I were in the government’s shoes, I’d see this as an opportunity, and India may actually be in a better position than many other countries.

India’s economy relies much more on service exports, which won’t be directly impacted by Trump tariffs. In fact, these services might even benefit. Many goods today, like cars or phones, are essentially services wrapped in physical products. If there are barriers to exporting goods, companies may shift to exporting services instead, which could work in India’s favour.

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Another opportunity lies in the possibility that if high tariffs are placed on China, India might be able to grab more market share, especially if tariffs aren’t imposed on India. So, while there are threats, there are also clear opportunities.

That said, the key to mitigating these threats would be reducing reliance on the US market. India is in a relatively good position for this, given that much of its goods exports — like steel and aluminium — can be sold globally.

However, for more specialised products like pharmaceuticals or engineering goods, India would need to identify alternative markets. The most obvious targets for this would be Europe and the UK. India has been negotiating free trade agreements (FTAs) with both, so it would make sense to focus on pushing those agreements forward to secure new markets.

We'd like to circle back to the 4.8 figure you mentioned earlier. You didn’t fully explain it — are you estimating that the growth rate will be around 4.8 per cent? If you look at the results from quarters one and two, they were quite poor last year, and this year’s projections aren’t looking much better. Quarter two has been particularly underwhelming. To be fair, the government has been conservative in estimating next year's growth. Politically, the target is often 8-10 per cent, but the government’s own estimate is only between 6.3 and 6.8 per cent. Given this, the government itself seems cautious about its growth expectations.

Yes, the 4.8 per cent figure represents the average growth of the Indian economy since fiscal 2020. As I mentioned earlier, these years were somewhat distorted — first by the pandemic, then by the subsequent rebound. But the question remains: what if the potential growth rate is actually around 5 per cent?

One thing that worries me, which hasn’t been discussed enough in the media, is the role of the GCC (Global Capability Centres) boom over the past few years. Specifically, in 2022 and 2023, the economy benefited from a surge in service exports driven by GCCs. In 2022, there was a major spike in service exports due to companies outsourcing large amounts of work to India as they adjusted their post-pandemic plans. Many people secured well-paying jobs at these GCCs, and they used their newfound wealth to buy flats, SUVs and invest in other consumer goods.

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By early 2024, this boom had fuelled a significant rise in construction, SUV sales and credit. But by the end of 2023, the inevitable slowdown began. Once people had bought their homes, furnished them and purchased their cars, there was less demand for large expenditures. Consequently, construction activity, SUV sales and credit growth all slowed, and this is reflected in the GDP numbers.

What I’m getting at is that it’s not just a temporary downturn over the last few quarters. Rather, it’s the end of a temporary surge from a few years ago that had boosted the economy. Now, we’re likely returning to a more normal growth rate — unless new investments are made or another export boom occurs.

Since you mentioned GCCs, India’s manufacturing sector has been stagnant for a long time but services have been performing well. Some believe that India has a lot of potential to grow in services rather than focusing on manufacturing. Do you think India should avoid trying to emulate China, which is a global manufacturing hub, and instead focus on becoming a services hub for the world?

Of course, India can become a services hub. But there are really two questions to consider. First, how much potential is there to increase services exports, particularly in areas like GCCs? Honestly, I have no clear answer to that. I haven’t seen any strong analysis on this, though it’s certainly possible.

The second question is about the supply side. For India to become a true services superpower, it needs far more talent than it has today. That would require major education reforms, starting from primary schools, which I haven’t seen happen yet. Without these reforms, there’s a risk of leaving many people behind.

For example, those with the right education have done really well in recent years. The rise of GCCs has created high-demand jobs for educated individuals, pushing up salaries across the board for skilled workers. This has been great for people like us. But for those without the necessary education to land such IT jobs, life remains much harder. Until we address this education gap, it will be tough to get more people into those high-quality jobs.

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Having reviewed your 2019 paper, where you advocated for reforms similar to those of 1991 in light of balance sheet issues? Do you still believe such reforms are necessary in the current context? Given your suggestion that growth might average closer to 5 per cent, do you think 1991-style reforms could still drive growth above 8 per cent, or are they more focused on crisis prevention rather than accelerating growth?

No, I don’t think India is facing a crisis. But to meet the aspirations of its people, it’s crucial that the economy grows rapidly. While a 5 or 6 per cent growth rate may sound good on paper — it's higher than many other countries — it’s not really what people have in mind. What people are hoping for is something like what China achieved, where the economy grew at 10 per cent year after year for decades. That’s the kind of transformation people want to see — something that happens within one generation. In my view, a lot needs to be done to reach that level of growth. My concern is that if things don’t change, India might end up stuck at around 5 per cent growth.

Lastly, the RBI Monetary Policy Committee outcome is round the corner, and Finance minister Nirmala Sitharaman has reiterated her commitment to fiscal consolidation in the budget. Meanwhile, there's been a substantial injection of liquidity by the RBI. The cash reserve ratio, for example, was reduced from 4.5 per cent in December to 4 per cent. Given this, are we likely to see a rate cut in this session? And secondly, are we heading towards a gradual rate-cutting cycle?

That question is probably better suited for investment bank economists, whose job it is to make such predictions. However, I can say that since 2022, the RBI has been very focused on maintaining a stable rupee against the dollar. There's a bit of a tension in monetary policy right now – a three-way balancing act.