EDIT: AFTER THE TAX CUT

All eyes now on how the govt manages its finances

Union Finance Minister Nirmala Sitharaman surprised everyone on Friday by slashing the corporate tax rate. Indian companies not availing of any exemption can now pay 22 per cent tax. The effective rate with surcharge and cess for large companies has been brought down from 34.94 per cent to 25.17 per cent. Further, companies getting incorporated in the manufacturing sector from October onwards, and starting production by March 31, 2023, will have the option of paying an effective corporate tax of 17.01 per cent.

While the government also extended relief for share buybacks and rolled back the enhanced surcharge on capital gains, introduced in the July Budget, the reduction in corporate tax is by far the biggest direct tax reform in many years, and will have multiple benefits. For one, it was a big sentiment booster, which was reflected in the biggest single-day rally in a decade on Dalal Street. The market now believes that the government can take bold decisions. Second, lower tax outflow will leave more cash with firms and can help boost investment. Third, aside from rate reduction, it is also a step forward in streamlining and simplifying the direct tax structure. Fourth, the competitive rate of taxation will increase India’s attractiveness as an investment destination, especially for companies moving out of China. For instance, Vietnam and Thailand have 20 per cent as tax rate, while Indonesia’s is at 25 per cent.

The big question, however, is whether the reduction will help revive economic activity in the near term. The tax cut will result in a revenue loss of ~1.45 trillion. In the near term, lower tax outflow should allow companies to reduce prices and help revive demand to some extent, though growth is likely to remain muted, at the least in the next few quarters. The bigger issue is how the government manages the fiscal impact. Most economists believe that the corporate tax cut will push the fiscal deficit to close to 4 per cent of gross domestic product. Growth in tax collection is fairly muted and achieving the revenue target looks an almost impossible task. That the tax cut has complicated the fiscal situation is evident from the way the bond market behaved on Friday. Since lower collection will affect transfers to states, their finances would also come under pressure.

Therefore, it is possible that the fiscal deficit will go up, both for the Centre and the states, and the government will appropriate more savings from the system. This will put pressure on interest rates and affect economic activity in the private sector. While the Reserve Bank of India (RBI) is widely expected to cut the policy rate in October, a higher general government deficit will impede transmission. Also, large interventions by the RBI to keep a lid on bond yields through open market operations can potentially become incompatible with its inflation-targeting mandate. Since the Budget numbers have lost their relevance, the government would do well to come up with a fresh fiscal consolidation road map, which will help instil confidence in the system. This will also help the monetary policy committee to take a more informed decision.

Aside from allaying fiscal fears, the government should complement the tax cut decision with other structural reforms such as those of land and labour to improve the ease of doing business and further enhance India’s competitiveness.