Opinion | An attempt to kick-start the investment cycle4 min read . Updated: 08 Oct 2019, 08:35 PM IST
Corporate tax rate cut is not a magic bullet to solve growth woes but it does lift the spirits
It has been said that governments in India stare at the many problems and their possible solutions simultaneously. But the point where the government decides to act is unpredictable. It has very often been the case that such actions are highly correlated with periods when the economy is facing challenges. For example, the case for a simplified direct tax code (DTC) has been around for many years. Multiple committees set up to explore a new DTC have made the case for simplification, i.e., a lower effective tax rate to be accompanied by withdrawal of a maze of exemptions and special benefits. Like a bolt from the blue, the government on 27 September cut the corporate tax rate, unleashing one of the recommendations that has been in the various versions of the DTC.
This is a significant development for several reasons. First, it amounts to a dramatic simplification of the tax code. Companies get to pay a lower rate rather than have a system riddled with exemptions and benefits. Second, tax rates have now been made comparable to that of many other geographies thereby ensuring that India does not lose its relative attractiveness. Third, an even lower tax rate for new investments is a welcome supply side measure to get businesses to invest more. Finally, a lower and simpler tax code aids and encourages businesses to corporatize and come within the tax net instead of operating in the grey area of evasion or worse—the black economy. This has elements of a welcome supply side reform and elements of a fiscal stimulus. This is a conscious step to leave money in the hands of the businesses that make choices about investing, hiring employees and producing the goods and services that customers value. The owners of businesses and the providers of capital get to decide how to use these increased benefits. Some may choose to lower prices for customers and others may choose to step up their hiring and spending plans—both revenue and capital expenditure. It can be argued that business owners are more likely to make productive use of this capital than the government and its bureaucratic machinery. Over time, this could lead to a virtuous cycle of higher growth and eventually higher tax buoyancy. It is a risk but a risk worth taking. An economy at India’s stage of growth cannot resolve its fiscal, demographic and growth challenges by restraint. Growth is an essential part of the solution.
Back of the envelope calculations suggested that the Nifty EPS for FY20 could ceteris paribus rise by 7-8% just on the back of this tax cut. As this is a recurring benefit, the impact is not just for a year; the cash flows accruing to business has increased in perpetuity. This one move single-handedly reverses the declining trend in forward earnings estimates. And obviously, the market has taken cognition of the same and rallied hard. When combined with the many measures announced in recent weeks, this headline-grabbing measure increases corporate India sense of well-being and potentially rekindles the animal spirits.
Obviously, those with a significantly higher rate of tax are the biggest beneficiaries. Companies in sectors such as consumer staples, consumer discretionary, healthcare services and financials are among the biggest beneficiaries as many companies in these sectors paid tax near the highest marginal tax rate. Sectors such as information technology and pharmaceuticals operate at tax rates nearer to the new peak marginal tax rate and as such there is no near-term earnings upgrades. However, even in these companies, when you think about cash flows accruing to these businesses in perpetuity, they do benefit because the likely prevailing assumption was that they would pay rates near to the marginal tax rate in the future. In regulated sectors such as, say, utilities, taxes are a pass-through item and hence, these companies remain largely unaffected. In capital-intensive commodity sectors, there are benefits due to increased cash flow to shareholders though earnings impact maybe more muted as many of these companies operate at lower effective tax rates.
However, it is important to note that not all businesses can retain such exogenous benefits. In competitive businesses where companies are price takers, such exogenous benefits are often competed away over time. Irrespective of this, there is a material change in pass through of cash flows to shareholders and hence this has the same positive impact on investment decisions by companies as would a reduction in the cost of capital.
This is not a magic bullet to solve India’s near-term growth woes though it does lift the earnings and spirits. Demand is weak, capacity utilization is not at its peak and credit markets are strained. This tax cut re-capitalizes Indian companies and gives them the ammunition to fire up growth; a welcome step towards rebalancing in favour of the investment cycle much like when you want to build a wall—you build it one brick at a time. Now we need to fix the credit delivery problem and establish a resolution process from financial entities. Many businesses continue to point to land and labour issues and very soon policymakers will encounter that very Indian phrase—aur dikhao.
Vetri Subramaniam is head-equity, UTI Asset Management Co. Ltd. Views expressed are personal.