Both income tax and the goods and services tax have both been reduced this year, costing the exchequer around ₹2.5 lakh crore. In his speech to the country last Sunday, the Prime Minister said he hopes this will result in greater demand and, therefore, higher economic growth.
Will it? If so, for how long? The answer lies in what economics calls the price effect and the income effect. The analysis is contained in what’s known as the Slutsky theorem in economics.
It’s taught in the first month of the first year in an economics class. In other words, it is the most elementary economics which is indispensable for that reason.
Eugen Slutsky, by the way, was a Russian mathematician and physicist in the first half of the 20th century. Like many such persons, he turned to economics later in life.
He came up with a formulation that is known as the Slutsky equation. It breaks up the effect of a price change into two parts: the substitution effect which is change in demand due to something becoming relatively cheaper or costlier; and the income effect which measures the change in demand because of a change in income.
Slutsky said that the “sum of these two effects equals the total change in demand, providing a way to understand and quantify how a price change impacts consumer behaviour.”
I am sure officials in the Finance Ministry kept Slutsky’s equations in mind while reducing income tax and GST. But, heaven forbid, if they didn’t. The Prime Minister will not be pleased.
Hope over experience
He is probably going to be disappointed because, actually, there’s another little wrinkle from Microeconomics 101. This is the difference between movements along a demand curve and a movement of the demand curve itself.
The government is hoping that it will be that latter, i.e., movement of the entire demand curve and therefore that total demand in the economy will go up. It is far more likely, though, that it will be the former, meaning that there will be a strong substitution effect between brands and within brands but overall demand won’t increase by all that much. It might even sink back to pre-September 2022 levels.
This is where the income effect comes in. It is only when incomes go up and stay up and keep rising that the entire demand curve moves up.
This is where the current Indian problem lies. Incomes are not going up by as much as is needed and, indeed, are falling in many cases — example, the IT sector.
Entry level salaries there have remained at the same level, of about ₹30-36,000 per month, since 2012, at least in the larger IT companies. Elsewhere these salaries might be a little more.
That, when you think about it, is a very long period of income stagnation. It affects the psychology of consumption very deeply and very negatively.
What’s happened to the IT sector has happened, with knobs on, in other sectors. Average incomes have stagnated around ₹20,000-25,000 per month. Entry level salaries are even lower. Every item bought is made to last longer.
Sociology and economics
Basically it has to do with urbanisation and its social and economic costs. Two things happen as a result of urbanisation.
One, the old joint family breaks up into what are called nuclear families. This prevents cost sharing by members of the family of overheads and thus leads to a duplication of such costs.
Second, the cost components of urban India have a high element of fixedness: rent, transport, communication, entertainment, education, health, and energy. Together, these can account for as much as three quarters of the income of an average family or even more.
If there are two earners the burden per person comes down a little but remains fixed and high in family terms. This, in turn, means very little room for discretionary spending. Expenditure is tax agnostic.
Now, since these costs are neither going to remain fixed, there’s only one way by which private consumption demand can increase sufficiently to move the entire demand curve up for all or most products: either increasing incomes vertically, which means increasing productivity; and horizontally, which means more employment; or ideally, both.
But here’s the problem: if one happens, the other doesn’t. That is, if productivity per capita increases, employment doesn’t.
Also, higher applications of technology, even in labour intensive activities, will prevent adequate growth in employment.
This has happened all over the world, throughout history. It’s happening as I write this. India isn’t going to be an exception.
Published on September 29, 2025