MUMBAI : On 20 September, finance minister Nirmala Sitharaman announced that the government had decided to cut the corporate income tax rate to 22% (effective rate of 25.17% including cess and surcharge) for existing firms, and to 15% (effective rate 17.01%) for new domestic firms in the manufacturing sector. This was subject to the condition that the companies availing these tax cuts will not claim any tax exemption/incentive. The government said this was being done to promote growth and investment.

Chief economic adviser Krishnamurthy Subramanian had said earlier this month that investment is the key driver of growth and consumption. The logic here is straightforward. Investment creates jobs. Jobs provide income to people. People spend this money and this spurs consumption and helps other people earn an income as well. These people also spend money and provide a further fillip to consumption. So, the cycle works.

What is indisputable is that the state of investment in the Indian economy has been down in the dumps (see chart 1). The value of new investment projects announced during April to June 2019 was the lowest in 15 years. From this logic, the government’s decision to provide tax sops to all present corporates, and future corporates in the manufacturing sector, makes sense, at least theoretically. But the question that no one seems to be asking is that are corporates in the mood to invest currently. Or to put it in economic terms, do they have an incentive to invest right now?

Investment in new projects has fallen to a 15-year-low.
Investment in new projects has fallen to a 15-year-low.

In order to answer that, we need to take a deeper look at the issues that arise out of the move to cut taxes.

■ India currently is going through a major collapse in consumer demand. Car sales, motorcycle sales, scooter sales and even moped sales (yes, we still produce them) have collapsed since the beginning of this year. Tractor sales and commercial vehicle sales have also collapsed.

In this scenario, it is more important to revive consumer demand. One possible way to do this could have been a reduction in personal income tax rates. The argument offered against this is that not many people pay income tax in India.

In an answer to a question raised in the Lok Sabha in July earlier this year, the government had pointed out that the number of tax filers for assessment year 2018-19 (or financial year 2017-18) was 84.4 million. Since then, the number would only have gone up. It is safe to say that more than 90 million individuals will file income tax returns in the current assessment year. Of course, everyone who files taxes does not pay taxes as well.

If we consider the income tax returns for assessment year 2017-18 (or financial year 2016-17), around 57% of those who filed returns also paid income tax. Using the same proportion we can say that around 51 million (57% of 90 million) Indians would have paid tax this year.

Now, 51 million out of a population of 1.3 billion is a small number. But what needs to be taken into account is that many of these individuals represent a household, given the very low female labour participation rate. An average Indian household has five individuals. Also, these are the individuals who have the real purchasing power in the Indian economy.

Further, cutting income tax rates is the quickest way possible to put money into the hands of people. Lower taxes would mean a higher income and that, in turn, could lead to increased consumer demand. During the period, April to June 2019, private consumption expenditure grew by just 3.1%. Consumption forms around 55% of the Indian economy and, hence, there is a great need to revive it.

■ One logic offered in support of the cut in corporate tax is that with lower tax rates in place, the firms will cut prices in order to attract consumers. Let’s compare this option with the option of the government cutting personal income tax. In case of a personal income tax cut, the higher income lands in the hands of the consumer, and he can decide what he wants to do with it. He can spend it or he can save it.

In the case of a corporate tax cut, the corporate may or may not cut the price of its goods or services, and hence, the consumer is dependent on the corporate’s decision for his spending decision. This makes very clear which is the better option when it comes to getting the consumer spending going.

Over and above this, as Rusmik Oza, head of fundamental research, Kotak Securities, points out in a research note, the effective rate of income tax for Nifty 50 companies, on an aggregate basis, was 26%. This will now come down to 25.17%. Given this, when it comes to India’s top companies, there isn’t much scope for a major price cut.

A research note by Crisil goes into more detail on this issue (see chart 2). If we look at companies with a revenue of 1,000 crore or more (1,074 such companies exist), the effective rate of tax is 27.6%. In this case, there is some scope for a price cut. On the whole, there is some space available for companies to carry out a price cut but not by much.

The new cuts would mostly benefit companies with a revenue of over  <span class='webrupee'>₹</span>1,000 crore.
The new cuts would mostly benefit companies with a revenue of over 1,000 crore.

Further, those who believe that the cut in corporate income tax is going to lead to price cuts haven’t really tried to answer whether companies actually do pass on the benefit of a corporate income tax cut to the end consumer.*

Also, it is worth remembering here that if companies want to move to an income tax rate of 25.17%, they need to give up the usage of any tax exemption or incentive. Also, once the option is exercised it cannot be subsequently withdrawn. This basically means that once a company chooses to give up the usage of exemptions and incentives while filing its returns, it cannot go back to using them. Given this, it is possible that companies are going to take time making a decision on whether they want to give up on exemption and incentives.

■ The stock market has of course welcomed the decision. The Nifty 50 has risen 7.5% from the close on 19 September, a day before the decision was announced, to 25 September. The rise is understandable given that with a lower tax, company profits are bound to go up. The question is by how much? Oza of Kotak estimates that earnings of companies that constitute the Nifty 50 will go up by around 5-6% during this financial year. When we take this factor into account, the stock market has clearly overreacted to the decision. Of course, banks and financial services companies will benefit more primarily because they don’t or can’t use many tax exemptions and incentives. An estimate made by CARE Ratings puts the tax savings of banking, finance and insurance companies at 17,679 crore. Not surprisingly, the share price of private banks, which pay a bulk of the income tax among banks, has risen dramatically since 20 September.

Also, it is worth remembering here that stock brokers need a story to peddle in order to get people to trade. The cut in the corporate income tax rate has provided them with such a story. Hence, it is not surprising to see a whole host of reports predicting very high Nifty and Sensex targets by the end of this year.

But as of now, all that has happened is that company earnings have got a one-time fillip from the corporate income tax cuts. Beyond this, any improvement in earnings will only happen as and when the consumer demand revives. This is well worth remembering every time a stock broker sings happy days are here again.

■ The government has also introduced a low rate of tax (17.01%) for new firms in the manufacturing sector. As Crisil Research puts it: “The drop in tax rate would now bring India on a par with most Asian economies." The conventional wisdom is that this will encourage corporates (both Indian and foreign) to set up new manufacturing businesses in India and will encourage Make in India. The stock brokers have also latched on to this story. Nevertheless, a low rate of income tax is just one of the things that foreign-companies look into while deciding whether to locate a unit in a country or not.

The government needs to follow up on the low tax rate announcement with factor reforms, and as cliched as it may sound, in the areas of land and labour. Over and above this, take the case of Indian ports. They play a crucial role in Indian trade. They handle 95% of the merchandise trade by volume. But the turnaround time of most Indian ports, except for a few private ports, continues to remain high. Turnaround time is essentially the time taken by a ship between berthing at a port and leaving it.

■ Many Indian companies are currently sitting on considerable idle capacity (because very few are buying). In this scenario, there is hardly any incentive for them to invest and expand. The collapse of consumer demand has also not helped. In this scenario, it becomes even more important to first revive some consumer demand, before trying to do anything else.

■ The government expects that the corporate income tax cuts, along with a few other measures announced on Friday will cost it 1.45 trillion. This is nearly 19% of the total 7.66 trillion that the government expected to collect as corporate income tax at the time of the presentation of the budget. Doubts have been raised about this number and the emerging view is that the government is being too pessimistic. Crisil believes that the top 1,000 firms will see tax savings of 37,000 crore. This is nowhere near the government estimates. Another point that needs to be considered here is that some companies may decide to give up on the exemptions and that might limit the damage to the government tax collections as well.

There are two things that need to be mentioned here. First, the so-called tax stimulus of 1.45 trillion may not end up being as big as it is being made out to be. Second, the government may not have to borrow much more. But that still doesn’t solve the problem on the fiscal deficit front. Fiscal deficit is the difference between what a government earns and what it spends. Before the corporate income tax cut, the government expected to earn 23.2 trillion from its five big taxes (corporate income tax, personal income tax, goods and services tax, union excise duty and customs duty) this year. This is 20% more than what it had earned last year. During the first four months of the current fiscal year, the gross tax revenue has gone up by just 6.6%.

This basically means that unless the government cuts its expenditure, it will end up with a higher fiscal deficit than the projection of 3.3% of the gross domestic product (GDP).

It won’t be surprising if the fiscal deficit crosses 4% of the GDP. This will mean that the Centre will have to borrow more in order to meet its expenditure, leaving less money for others to borrow. In this scenario, the chances of interest rates coming down further go for a toss. The larger point being that an easy monetary policy and an expansionary fiscal policy cannot be run at the same time. Also, the government has to share its tax collections with states. Hence, with the tax collections taking a hit, the state governments will also end up in a spot of bother. And public spending, which again could be a tool to revive demand, will be hit.

To conclude, India does need lower corporate income tax rates to encourage investment, but as of now, what it really needs is a revival in consumer demand. Everything else comes after that.

Vivek Kaul is an economist and the author of the Easy Money trilogy.

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