The government’s corporate tax move is bold. But there is a fiscal risk
It will potentially leave investors with more money, make firms competitive, and boost consumption
Private consumption, the only engine of the economy that had been firing most consistently in recent years, is losing steam. Two other engines — investments and exports — seem to be slowing down again. The result is 5% growth. To boost growth, the government, on Friday, decided to risk the only engine of the tax system that has performed lately — corporate tax. In 2018-19, the actual collection (provisional) of corporate tax was ₹ 6.63 lakh crore, against the budgeted ₹ 6.21 lakh crore. The collections under personal income tax, Goods and Services Tax, and union excise duty were much lower than budgeted.
The government’s finances have been under pressure. It has not been able to cut expenditure, and tax collections have not grown at expected rates. To meet the fiscal deficit target, the government has pushed a lot of borrowing off-budget, making government agencies borrow more. It has also allowed the National Small Savings Fund (NSSF) to lend to a number of government agencies. The government and its agencies now corner most of household financial savings in India.
In this context, cutting corporate tax rate is a very bold move . It is a fiscal risk — as the government will forego ~1.45 lakh crore in possible revenues — being taken to boost growth by way of increased private investment.
The new structure of corporate tax rates leaves more money in the hands of investors to save and invest in a manner of their choosing (in India, tax incidence is mainly on capital or investors); it can help Indian firms become more competitive globally; and it can boost consumption by lowering the price of goods and services.
The nature and scale of impact of this move will, however, depend on four factors.
First, will the decision signal a deeper change in tax relations between the government and the firms? It is a bit strange that corporate tax collections have been growing rapidly in a difficult economic situation. Perhaps the revenue department is under pressure to collect more taxes than was reasonable. One place where this shows up is in the corporate tax collection under dispute, which increased from ₹ 3.07 lakh crore in 2016-17 to ₹ 3.99 lakh crore in 2017-18 (data not available for 2018-19). No other type of tax saw a comparable rise in amounts under dispute. It seems the department is collecting more from firms than is due, even if a lot of it goes into dispute and is not eventually realised.
The tax cuts must be accompanied by a signal to the revenue department to rationalise its approach to businesses, or it could add to the pressure that the department is under to deliver on revenue targets. In other words, how this change in tax policy impacts tax administration is crucial. The government should take this opportunity to redefine its approach to tax policy and administration with respect to businesses.
Second, how will the government pay for these tax cuts? India is a country with considerable capital controls, especially on debt instruments. So, borrowing by the government and its agencies from domestic markets crowds out the private sector, unless it is used for investments that encourage more private investments. The economic effects of the government borrowing, directly or indirectly, from banks or from NSSF, are not very different. The way the government will manage its overall public finances after these tax cuts will shape the outcome of this decision. This tax cut may lead to lower tax collection in the short to medium-term. If the government then borrows more (on-budget or off-budget), it would limit the benefits by making it more expensive for firms to borrow. So, the government must reduce unproductive expenditure while cutting the tax rate.
Third, the benefits will depend on how the firms choose between the available tax structures, and which firms are able to really benefit.
The existing incentives on corporate tax added up to ~1.2 lakh crore in 2017-18 and were projected to be ~1.4 lakh crore in 2018-19. After adjusting for Minimum Alternate Tax, these were ~0.93 lakh crore and ~1.09 lakh crore, respectively. The biggest incentives are for accelerated depreciation, for export profits from special economic zones, for expenditure on scientific research, and for profits of power sector firms. Firms will have to choose between availing these incentives and going for the flat tax rate. So, the net effect will be smaller than it appears. For instance, in 2017-18, the effective tax rate for firms with more than ~500 crore in profit was only 26.3%, because they had availed tax incentives. So, for them, the net effect will be smaller. Overall, about 45% of the total profits generated by corporates is in firms with effective tax rates of less than 25%. This move will mainly affect the other firms, and all new domestic firms in manufacturing. In the coming months, we will see firms making these choices, which will determine the overall economic impact.
Fourth, the overall impact will also depend on what else the government does to boost the investment environment in India, in terms of improving access to foreign capital, solving problems of public sector banking, easing infrastructure constraints, improving contract enforcement, and so on. These structural issues will continue to affect choices that firms make, and even a big tax cut is not a substitute for those reforms.
The move to cut corporate tax rate is consistent with the Indian government’s tendency to reform from crisis to crisis. Due to the context, this reform is also a big fiscal risk. Its overall impact will depend on certain choices that the government and the firms will make in the next few months.