India’s Big Bang Tax Reform: A Laffer Curve Moment?

In 1981, when then-United States (US) President Ronald Reagan announced sweeping tax cuts, economist Arthur Laffer — famous for the “Laffer Curve” — quipped that tax policy wasn’t just about numbers but about human behaviour.

The right cut at the right time, he argued, could spark growth rather than shrink revenues.

His words have echoed through economic debates ever since, and nowhere is this search for “big bang” reform more evident than in India’s annual budget speeches.

Every year, as the finance minister steps up to her seat in Lok Sabha, economists, businesses, and citizens alike tune in with one question: What’s the big takeaway?

In 1991, it was Manmohan Singh’s sweeping liberalisation. In 1997, P Chidambaram’s “dream budget” slashed tax rates, making compliance simpler. In 2016, Arun Jaitley’s budget paved the way for the goods and services tax (GST), fundamentally reshaping India’s tax regime.

This year, the headline-maker was a substantial tax break — one that promises to put more money in the hands of individuals and businesses.

The rationale for an income tax cut in the Union Budget 2025 was anchored in the need to stimulate domestic demand amidst slowing economic growth and persistent inflationary pressures.

The Indian economy is experiencing a consumption slowdown, with household savings declining and wage growth stagnating, particularly in urban areas.

Empirical studies have shown that middle-income households exhibit a higher marginal propensity to consume (MPC), making them the ideal beneficiaries of targeted tax relief.

Additionally, given the fiscal consolidation roadmap, a well-structured tax cut — offset by rationalising exemptions or broadening the tax base — can be revenue-neutral in the medium term. This aligns with the Laffer Curve hypothesis, which suggests that beyond a certain threshold, lower tax rates can lead to higher compliance and tax buoyancy.

Furthermore, against the backdrop of global uncertainties, including potential trade restrictions from the US, boosting domestic consumption becomes critical to sustaining growth.

Therefore, a strategic income tax adjustment in this budget would not only provide relief to the middle class but also serve as a prudent counter-cyclical fiscal measure.

The proposed personal income tax reforms in this budget introduce a significant restructuring of tax slabs, particularly benefiting the middle class.

Under the new regime, the exemption threshold has been raised to Rs 4 lakh, with a progressive tax structure capping at 30 per cent for incomes above Rs 24 lakh.

The most notable change is the enhanced rebate, which now ensures that individuals earning up to Rs 12 lakh effectively pay no tax. This is a substantial improvement from the previous Rs 7 lakh threshold.

For instance, an individual earning Rs 10 lakh annually will now save Rs 50,000 in taxes compared to the old regime, while someone earning Rs 12 lakh will benefit by Rs 80,000.

These measures not only reduce the direct tax burden but also increase disposable income, improving financial flexibility for millions of middle-class households. 

Additionally, a higher disposable income could encourage greater savings and investments, indirectly benefiting capital markets and long-term financial security. 

This change is expected to encourage more people to file income tax returns, even if they owe no taxes, as Rs 12 lakh is a relatively high income level for complete tax exemption. Since individuals in this bracket no longer face a direct tax liability, they are not disincentivised from entering the formal tax system.

This aligns with the “Prospect Theory,” developed by Kahneman and Tversky, which suggests that individuals tend to avoid losses more than they seek equivalent gains. Previously, those earning slightly above the tax-free limit may have avoided filing returns due to the perceived “loss” of paying taxes. By raising the rebate threshold, the government has reduced this psychological barrier.

Now, filing taxes carries no financial downside for many middle-class earners, fostering higher compliance and expanding the tax base over time. This could also lead to improved financial inclusion, as formal tax records often serve as proof of income for accessing credit and other financial services.

The government is set to forego Rs 1.1 lakh crore in revenue as a result of this tax relief measure, amounting to approximately 0.3 per cent of total revenue. This represents a classic trade-off in public finance between revenue mobilisation and economic stimulus. But, needless to say, this was important to drive both rural and urban consumption in India.

Apart from this, the budget introduces significant measures aimed at enhancing ease of living and doing business by rationalising tax compliance and simplifying financial regulations.

The rationalisation of tax deducted at source (TDS) and tax collected at source (TCS) rates reduces the multiplicity of rates and compliance burdens, ensuring a more streamlined tax regime. By lowering rates on transactions like securitisation trusts and timber sales, and increasing thresholds for various deductions, the budget eases financial operations for individuals and businesses alike.

Moreover, the extension of the time limit for filing updated tax returns from 24 to 48 months provides greater flexibility for taxpayers to voluntarily rectify their filings, promoting compliance without stringent penalties.

Additionally, aligning reporting requirements for crypto assets and simplifying rules for self-occupied property valuations further reduces ambiguities in financial reporting, ensuring a more transparent and predictable regulatory framework.

For businesses, the budget enhances operational efficiency through multiple tax reforms, including the extension of tax benefits for startups under Section 80-IAC until 2030, ensuring a stable policy environment for entrepreneurial growth.

The introduction of presumptive taxation for non-residents establishing electronics manufacturing facilities in India further incentivises foreign investment. The budget also harmonises capital gains taxation for non-resident investors, reducing distortions in investment flows.

Additionally, significant reforms in charitable trust taxation, business trust income treatment, and exemptions for International Financial Services Centre (IFSC) units create a more predictable and business-friendly tax structure.

The removal of higher TDS/TCS rates for non-filers and exemptions from prosecution for delayed TCS payments further ease compliance burdens, fostering a tax regime that prioritises efficiency over punitive enforcement.

These measures collectively enhance the ease of doing business in India, making regulatory compliance simpler while promoting investment and entrepreneurship.

Beyond taxation, the budget emphasises fiscal discipline, with the fiscal deficit projected to decline to 4.4 per cent of the gross domestic product (GDP) next year, reinforcing the government’s commitment to long-term macroeconomic stability.

Measures to streamline business regulations, promote financial inclusion, and strengthen the digital economy complement the broader economic vision.

In sum, the budget aims to balance growth with fiscal prudence, offering tax relief to individuals while fostering a business-friendly environment.