Corporate tax cuts and growth
Reduced rates will have little impact in the short run, but could have a significant positive impact on growth in the medium term
On September 20, Finance Minister Nirmala Sitharaman announced major changes in the structure of taxation for large Indian companies: The basic rate of company income tax was reduced from 30 per cent (35 per cent including cesses and surcharges) to 22 per cent (25 per cent including cesses and surcharges), a new rate of 15 per cent (17 per cent including cesses and surcharges) for new manufacturing companies (set up after October 1, 2019, and producing before March 31, 2013) was announced and the minimum alternative tax (MAT) rate was cut to 17 per cent (inclusive of cesses and surcharges). The proviso for enjoying these reduced tax rates was that companies had to give up their extant incentives and exemptions. Stock market indices soared and India Inc showered encomia. The reaction from analysts and commentators has been more mixed, ranging from euphoric (“real structural reform”) to guardedly welcoming and even extending to some who worried about fiscal “bonanzas” to the corporate sector at a time of serious fiscal stress. To help form a balanced view it might be worthwhile to outline some of the likely economic consequences of these undoubtedly major changes in company tax policies.
First, the tax cut obviously provides a fiscal stimulus in the short run. The government estimates a direct revenue foregone loss of ~1.45 trillion or 0.7 per cent of GDP. However, as various analysts have noted (such as A K Bhattacharya in Business Standard, September 24, 2019, and C Rangarajan and D K Srivastava in the Hindu Business Line, October 3, 2019), this may involve a significant overestimate, essentially because it may not have factored in the substantial revenue gains to the exchequer arising from companies giving up extant recourse to exemptions in order to benefit from the reduced tax rates. (Remember, that giving up exemptions is an essential precondition for benefitting from the reduced tax rates.) Budget documents show a total of revenue foregone in 2018-19 from corporate taxes on account of exemptions and incentives of ~1.08 trillion, mainly because of accelerated depreciation and export benefits. A good part of these may be given up in 2019-20 to avail of the reduced tax rates, bringing the net revenue loss from the tax reductions down to about 0.4-0.5 per cent of GDP. Other things equal, that amounts to a net fiscal stimulus of the same order.
Second, this stimulus will entail additional government borrowing to finance a higher fiscal deficit, leading to higher medium- and long-term interest rates, which will damp investment. This explains the post announcement increase in the yield on benchmark 10-year government bonds by about 20 basis points. So, some of the positive stimulus effects on investment and other expenditure will be negated by bond market developments.
Third, these major cuts in company taxes could have potent incentive effects on corporate investments. After all, a reduction in the tax rate from 35 to 25 per cent should significantly boost post-tax rates of return on extant and future capital. But there are qualifications. Because of the prevalence of incentives and exemptions, the impact of the tax cuts will vary enormously across companies, with many companies choosing to remain in their exemption-using status. Many of the firms which benefit most from the tax cuts already have large liquid balances and are unlikely to augment their capital expenditure plans in the short run. Other tax-saving beneficiaries will use the monies to deleverage and repair stressed balance sheets. An impact analysis by Credit Suisse issued on September 30 estimates that 90 per cent of the shortrun tax cut benefits will be either retained as additional profits or used for deleveraging. Of course, further down the road and subject to other economic/financial developments, one should expect positive effects on corporate investments.
Furthermore, the greatly reduced tax rate (from 35 per cent to 17 per cent) for new manufacturing companies should certainly spur investment in this sector (from both domestic and foreign sources) in the years ahead. But the amount of such tax-cutinduced investment will obviously depend on other key elements of the policy framework, such as labour and land policies, the state of the financial and infrastructure sectors, the general ease of doing business, other tax policies, fiscal prudence and the competitiveness of our exchange rate. If those move in a favourable direction, then the force-multiplier effect on investment could be powerful. The reverse also holds true.
Fourth, the tax cuts impart a clear signal in favour of private sector investment and activity. This should have an “animal-spirits-boosting” effect on company investment plans, in particular, and wider economic activity in general. However, this positive effect also will be conditioned by the broader policy environment factors alluded to above.
Fifth, some have argued that the big boost to stock prices from the September 20 actions will have enduring positive effects on stock market valuations and hence, wealth, which, in turn, will induce higher expenditure on consumption and investment. I am somewhat sceptical for at least two reasons. First, reliable quantitative estimates of “wealth effects” in India are notable by their scarcity. Second, share prices are more than usually volatile these days, as the last fortnight has amply demonstrated.
Finally, I wonder how much foreign investment the tax-cut measures will induce and in what sectors. Perhaps oddly, my concern is that if there is considerable foreign investment in non-tradeable sectors, this may shore up, or even further appreciate our already over-valued exchange rate. Recalling that an X per cent appreciation of the exchange rate is equivalent to a X per cent subsidy for imports and an X per cent tax on exports, I worry about the possible negative effects on investment and growth in our import-competing and export industries, unless we manage our exchange rate better than we have in recent years.
So what might be the overall net effect of the tax cuts on investment and growth in the short and medium term? It is obviously hard to say. My own sense is that they will have only marginal effects in the short run and significant positive effects in the medium term. “Significant” could change to “very substantial” if we also undertake meaningful reform measures in the other policy dimensions outlined four paragraphs earlier.