Why Volume Elasticity & Inelastic demand for Essential products have to be studied to make sense of the proposed GST tax cuts.
On India’s Independence Day (15th August 2025), our PM announced GST may be cut for many products as soon as Diwali (20th Oct 2025). Currently, we have four slabs — 5%, 12%, 18% and 28%. He mentioned that the 12% and 28% slabs may be scrapped, and only 5% and 18% may remain.
The government would prefer the tax cuts to reach the end customer efficiently, but an indirect tax cut (GST cuts) has a lower transmission efficacy than a direct tax cut (income tax cuts). There are two reasons for the same.
- Volume Elasticity.
- Inelastic Demand for Essential Products.
We shall learn about both these phenomena today.
Volume Elasticity
A bag of cement priced at Rs450 has a GST rate of 28%, i.e. Rs126 goes to the government and Rs324 goes to the manufacturer. A tax cut from 28% to 18% should mean the new rate of cement should be: 324+18% = Rs382.32 ~ Rs383.
Government is losing 28% minus 18% = (90.72–58.32) = Rs32.4 as taxes for every cement bag getting sold. Let us assume there are 100 crore cement bags that are getting sold every quarter, this translates into ~ Rs3240 crores of revenue loss for the Govt. To compensate for this loss, the sales of the cement have to increase from 100 crore cement bags to 1.56x, i.e. 156 crores.
This means that the consumption of cement in the country has to multiply by 1.56 times for the government to realize the same revenue as it was generating.
Is this possible? Yes, but only in the long term. In the short term, the demand for cement may not rise to 1.5x even if the prices drop from Rs450 to Rs383.
The relief would be felt at the end customer’s hands if this cost benefit is fully transmitted to them. The cost of constructing a house, property, or a bridge should come down proportionally to the weightage of cement used in it, but would it?
Secondly, the manufacturers may not allow this cost benefit to be fully transmitted. They would prefer to increase the rate from Rs324 to Rs381 to keep the final cement price at Rs450 per bag.
This is the damage an indirect tax cut can do to the economy, as the end customer may not stand to benefit that much. The people who would profit here are the cement companies. Similarly, manufacturers of other products, such as air conditioners and televisions, would do the same thing.
Inelastic Demand for Essential Products.
Products like soap, oil, toothpaste, and toiletries are still at 18%, and I do not expect a decline in GST for these essential items. However, a few of the essentials fall within the 12% bracket, and we hope that they will be shifted to the 5% slab instead of 18%. If so, a decline in the tax rate may not lead to a demand surge. The reason is due to demand inelasticity.
If the price of toothpaste decreases from Rs 50 to Rs 46.5, you do not start brushing three times a day and consume more of the toothpaste. Here again, the manufacturer would take the opportunity to increase the costs to match the final price if left free.
The demand is elastic only for luxury products, wherein we buy more of those goods when the price drops. A tax cut on luxury products will have a quick and profound impact on consumption, as people who were not able to afford them earlier will now be able to buy them.
The sale of luxury products will improve the GDP of the nation, but it will not fix the inequality and imbalance at the lowest strata of income earners. To make an impact on the middle class and poor people, the tax rates on essentials have to be reduced, and we should get a 100% transmission of cost cuts.
The only way an indirect tax cut can generate demand is by a complete transmission. The reduction of prices should reach the end customer’s level. Theoretically, a price reduction should encourage the customer to buy another item, so that the final outgo from their pocket remains the same. This is how a demand surge can be artificially created.
Let me illustrate with an example.
Assuming Mr. Ramesh’s household expenses are Rs 10000 per month on essentials. A GST cut from 12% to 5% would save him Rs 10000 — (12–5)% = Rs 700. If we further assume that Ramesh would prefer to spend this Rs700 again in the market, he gets to buy products worth: Rs665 and the Govt. gets Rs 35 as taxes (5% taxes assumed).
This additional product, which he buys for Rs700 out of every Rs10000 spent, should create a cumulative demand spiral in the nation. This is the best-case scenario, and for it to happen, two things must occur in tandem.
- The price cuts have to be fully transmitted.
- The end customer should spend the difference amount rather than save it.
The current government deserves praise for taking this initiative of tax cuts, even if it’s been delayed by 7 to 8 years. It is also commendable that they are correcting the items that were incorrectly placed in the wrong tax bucket. Sentiment-wise, it is a good message that is sent to all the citizens. It also gives the impression that the current government is listening to us all.
The stock markets react favorably to any tax cuts, not because the end customer is going to benefit, but because the investor stands to benefit first. The investor usually makes instant money, as these FMCG, consumer goods, and capital goods companies improve their operating margin and profits.
When these investors make more money, a second-order demand surge is created, which is more impactful in actually boosting consumption. Frankly, the 2nd order effect will overshadow the direct impact on end-customers, and the market sentiment will further iterate.
A fiscal policy, such as a tax cut, profoundly impacts the overall economic cycle, with the only limitation being the time it takes for the results to become apparent. Having said that, a tax cut is an excellent opportunity to invest rather than spend.
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