Q."The Government has raised the exemption limit for the payment of Income tax from ₹ 2 lakh to ₹ 2.5 lakh." If the situation of deficient demand is prevailing in the economy, what will be the impact of this action taken by the Government ?

Concept: Fiscal policy to combat deficient demand through changes in disposable income and aggregate demand.

Deficient demand occurs when aggregate demand falls short of aggregate supply at full employment, leading to underutilized capacity and unemployment. The government's action—raising the income tax exemption limit from ₹2 lakh to ₹2.5 lakh—is an expansionary fiscal policy measure.

Reasoning:

1. Higher disposable income: Individuals earning between ₹2 lakh and ₹2.5 lakh no longer pay tax, and those earning above ₹2.5 lakh pay tax on a smaller portion of their income. This increases disposable income across these groups.

2. Increased consumption: With more money in hand, households raise their consumption expenditure (especially on essential and semi-essential goods), directly boosting aggregate demand ($C \uparrow \Rightarrow AD \uparrow$). …

Why this policy works against deficient demand

Deficient demand arises when aggregate demand in the economy falls short of aggregate supply at full employment—output capacity exists, but people aren't buying enough. The economy operates below potential, unemployment rises, and inventories pile up. The government can intervene through fiscal policy to inject purchasing power into the hands of households.

When the exemption limit rises from ₹2 lakh to ₹2.5 lakh, everyone earning between these amounts pays zero tax instead of some positive amount, and those earning above ₹2.5 lakh also see a tax saving on the first ₹2.5 lakh of income. This leaves more money in people's pockets—their disposable income increases.

Step-by-step impact

1. Immediate effect: higher disposable income Taxpayers who were paying tax on income between ₹2 lakh and ₹2.5 lakh now retain that entire amount. For someone earning ₹3 lakh, the tax burden on the ₹50,000 slice (from ₹2 lakh to ₹2.5 lakh) vanishes. Disposable income $Y_d$ rises:

where $Y$ is national income and $T$ (tax collection) has decreased.

2. Consumption rises via the marginal propensity to consume Households spend a fraction of any additional disposable income—this fraction is the marginal propensity to consume (MPC). If MPC is, say, 0.8, then out of every extra rupee saved from taxes, 80 paise goes into consumption. Aggregate consumption $C$ increases:

3. Aggregate demand shifts upward

   Aggregate demand $AD = C + I + G + (X - M)$. With $C$ rising and other components unchanged in the short run, $AD$ shifts to the right. Firms see higher demand for goods and services.

4. Multiplier effect amplifies the impact

   The initial rise in consumption becomes income for producers, who in turn spend part of it, creating a chain reaction. The total increase in income is:

where $k$ is the Keynesian multiplier. A small tax cut thus generates a magnified increase in national income.

5. Output and employment respond

   Facing higher demand, firms expand production to meet it (since deficient demand means spare capacity exists). They hire more workers, unemployment falls, and the economy moves closer to full-employment equilibrium.

6. Inflationary pressure remains subdued

   Because the economy was operating below capacity, the rise in demand primarily increases real output rather than prices. Inflation stays in check as long as the demand boost doesn't overshoot potential output. …