Tax cuts: Structural gamble, not a cyclical solution

By Somnath Mukherjee

The expectations were building up a bit like MS Dhoni’s batting in the slog-overs. As hi-frequency indicator after hi-frequency indicator showed increasing softness in the economy (a bit like slow-scoring overs at the death), the expectations of a “big bang” announcement were ever-so-invariable. And then, the big hits came, in the form of sweeping reduction of corporate tax rates for existing businesses, and even deeper cuts for new units being set up. Are they enough to take India to victory (or in this case, boost growth)?

Depends on what one frames as “victory”. If it is framed in the bailiwick of long-term structural reforms, then these reductions are indeed a very necessary component of the framework. India’s tax rates have long been uncompetitive against regional (and even global) peers – and a rationalisation of the same was sorely required and promised by successive finance ministers (including via the longdebated Direct Tax Code).

The concessional tax rate of 15 per cent for new units set-up is a clever example of fast follower — Thailand and Vietnam have both done similar tax cuts recently, specifically targeting firms looking for alternatives to China in view of the US-China trade war. The structural reforms menu is a long one though — encompassing factor markets, personal income taxes, GST rationalisation and some more. Ergo, in order to succeed, this cannot be a silver bullet.

Corporate tax rates aren’t like personal income tax (PIT) rates — they don’t conform typically to the famous Laffer Curve axiom (wherein a reduction in tax rates increases compliance and thereby improves aggregate tax collections for the government by increasing compliance). Reduction in corporate tax rates is therefore a gamble on spurring long-term growth, not one of increasing compliance.

However, if the objective was framed to counter the current slowdown — this leaves out most of the key boxes, barring that of equity market sentiment (a very important, albeit rather fickle variable determining economic outcomes). To understand this, its useful to start from the basics. Fundamentally, GDP = Consumption (C) + Investment (I) + Government Expenditure (G) + X(Exports) – M(Imports).

Of the four pillars, the Indian economy has been constrained on 2 — I and X — for more than five years, due to several reasons. The prime motors in this period have been G (aided by oil tax windfalls and increased direct tax buoyancy) and most critically, C. It is this last pillar, C, that has slowed down in recent months. With consumption contributing more than 50 per cent of GDP, this has had a debilitating impact on growth. Lack of “C” effectively means there is a lack of demand. A counter-cyclical fiscal policy is the right tool to address demand issues.

First, on the math. As usual for Indian fiscal policymaking, they don’t add up. While the government has indicated a revenue loss of Rs 1.47 lakh crore (or an earnings boost to Corporate India to that extent), it doesn’t add up. CRISIL, via its large company database, arrives at a number ofRs 37,000 crore. Back-ofthe-envelope calculations, stresstested, don’t come up beyond Rs 1 lakh crore either. While we have to wait for actual corporate announcements/results to gauge the real impact, the quantum is seemingly rather less than the headline.

Further, the choice of corporate tax rate (CTR) cuts is curious, because it has several slippages in terms of transmission of the fiscal boost into aggregate demand. To start with, more than 99 per cent of all firms were already paying the lower (25 per cent) tax rate. In other words, the extant tax cut basically benefits a small number of large firms.

Second, will they invest more, taking up ‘I’ materiallyRs That’s doubtful – investment is usually a function of capacity utilisation, and that is still stuck at 75-76 per cent for the manufacturing sector. While the ultra-low tax incentive for new units could attract some new investments, it will be a while before they start moving the dial meaningfully.

We can evaluate a bit more by identifying firms that are benefiting, and how much they could actually save. While tax statutes are often complex in their fine-print, a very high level estimation using listed companies PBT and PAT numbers can be done. Using the BSE500 as a base, roughly 20-21 per cent of taxes are paid by financials – while some of them will use the excess capital in order to expand their balance sheets, many of them (especially PSU banks) will simply use this to shore up capital deficiency. Energy and materials companies are the highest contributors, contributing nearly half of all taxes paid by BSE500 companies. Will they invest more, especially given the global overcapacity in a range of metals, oil refining and related industriesRs

Now, part of the windfall is likely to be passed on either through price cuts or paying out higher dividends — both boosting consumption. To the extent of extra dividends with shareholders or lower prices, there is a consumption boost. Whether that is nearly enough, or even an appreciable percentage of the Rs 1.45 lakh crore that the government has estimated to be the fiscal hole, is an open question.

Third, the fiscal hole has a further complicated collateral impact. Given that the reduction has been in benchmark tax rates and not on cess/surcharges, state governments will bear 42 per cent of the fiscal hit, while the Union government will take about 58 per cent of it. Given the hard limit (3 per cent of GDP) on the fiscal deficit of the states, this would mean several of them would cut back on spends, reducing aggregate ‘G’ somewhat. Separately, there will be incremental bond supply from both Centre and states to fund the fiscal hole, putting incremental pressure on interest rates. In a perverse way, that could also increase interest rates for large corporates, thereby mitigating somewhat the impact of the tax cuts!

It is arguable that fiscal boost would have been far more immediately impactful on consumption and demand if it was directly delivered to consumers (via a cut in PIT, or direct cash transfers like NREGA and PM-KISAN schemes). A fiscal stimulus package based on corporate tax cuts doesn’t address the problem of consumption demand, especially rural demand.

The real story is therefore not of today’s crisis, but potentially tomorrow’s opportunity. It’s a policy trade-off — and only time will tell whether it was worth its while!

(The author is managing partner, ASK Wealth Advisors. Views and opinions expressed are personal.)