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Corporate Tax cut

Updated: Nov 9, 2019

The decision of the government to cut the Corporate tax rate from 34.3 % to an effective rate of 25.17% has brought cheers to the Industries already grappling with the economic slow down.

This measure has been the single largest tax rate cut by the government, bringing India’s tax regime at par with the globally competitive markets and making a strong case for investment in India. From a domestic policy perspective, the situation looks primed to benefit the “wealth creators” as mentioned by the PM in his speech.

Why corporate tax rate cut?

The corporate Tax cut is more like an Income tax rate cut and the policy could be easily implemented starting the next Financial year, Moreover, the governments focus to make India the Manufacturing hub under “ Make in India” would be aided by this measure. Because of the high tax regime, India was not able to attract FDI into the country. A lower tax rate would not only ensure greater corporate profitability but also make India a more competitive market for Investments.

Impact on economic activity

The impact of tax rate cut can be view from two perspectives.

1. Immediate Impact:

On the immediate term, it leaves the corporates with more money, which can be utilised by them to either reinvest in existing firms or invest in new venture (capital creation). However, it is also possible that the surplus money may be utilised towards repaying debts or pay a higher dividend to shareholders. Whether or not the company decides to further invest the fund depends on the prevalent macroeconomic scenario. Investment decisions is crucially dependent on the consumption levels prevalent in the economy. If there is a higher consumer demand for Cars, FMCG products, the firms would prefer to invest. However, with the consumption levels being depressed across sectors, the businesses would not like to go for a phase of capacity expansion presently.

2. Medium term Impact:

In the medium to long-term ie. anywhere between 2-5 years, a corporate tax cut is expected to boost investment and increase productive capacity of the economy. This is because regardless of a slump in demand in the short-term, investment decisions are taken keep in mind the future demand projections. If the demand is expected to grow, investments will bear fruit and with lower taxes, profits will be higher. These investments will also create jobs and increase earnings in the due course.

Was tax rate cute the right measure to boost the economy?

The measure of the government had been critiqued by many as a knee-jerk reaction to present slowdown and as a measure to boost the stock markets up.

While it is difficult to argue that it would, there are greater chances that India’s GDP growth will continue to struggle in the current financial year despite the rate cuts, owing to a multitude of reasons.

1. Inventory pile-up:

The official statistics of the government show that workers in several key economic sectors such as agriculture and manufacturing have seen their incomes stagnate. This has led to joblessness in the country and the areas which have continue to grow have seen a phase of jobless growth, leading to a fall in the employment level in the country. This essentially means that peoples buying power has been severely constrained and that is why there is fall in consumption levels, resulting in higher unsold inventories which the corporates would first have to dispose before embarking on a phase of expansion.

2. No direct correlation between rate cuts and Investments:

A report published by CARE ratings shows that 42% of the tax savings as a result of the rate cut will go to firms in the banking, financial and insurance sectors (BFSI segment). These firms can at best lend to others to aid growth, they cannot directly invest and start manufacturing activities. So, while the rate cuts will help the improve their balance sheets and make the financially sounder, there may not be an immediate boost to the economy. Labour- and Capital-intensive sectors are as it is plagued with the issues of over capacity and are thus unlikely to further invest to enhance their capacity.

3. The employment factor does not pay:

Higher the tax cut, higher the ability of the firm to pass on cost reductions to consumers in the form of lower prices and given that the demand is sufficiently price elastic, it would spur more demand, lead to increase in production and hence employment in that sector as the multiplier effect plays out.

However, in reality there may be no commensurate increase in employment since the most labour-intensive sectors, agriculture; textile manufacturing etc. are still plagued with various policy blunders that had stemmed their growth and are least likely to be affected by the cut. For eg : Since 2011-12, the gross fixed capital formation as a proportion of GDP in India has registered in negative CAGR -2.44%.

Textile manufacturing specifically is the second largest employer after agriculture but the sector has been unable to capitalise on the domestic presence of an entire value chain – from fibre, yarn, fabric and apparel along with affordable and abundant labour as India’s share in the global textile exports still remains a minuscule 5% in comparison to China’s 38% market share.

This is due to the policy failure with respect to Fibre neutrality. The differential tax rates in India (GST) with respect to Indian cotton (5%) and manmade fibres (12%) act as a cost impediment during exports given the global consumption ratio of cotton to manmade fibre apparel is 30:70 – this reduces cost competitiveness and misaligns exports with global market consumption.

Therefore, what is required is a sector specific growth plan and a not a blanket tax solution as each sector has its unique problems and a only a focussed tax plan would spur growth in such segments.

4. What happens to Fiscal deficit?

At the central level, the tax cut will lead to an estimated revenue loss of 1.45 trillion of Gross Tax Revenue (GTR) (ie. 0.7% of the GDP foregone) and will push the fiscal deficit to about 4.2% which far exceeds the government target of containing the Fiscal deficit to 3.5% of the GDP.

This might affect the government’s ability to expend and given that the fiscal expenditure multiplier (0.45 as estimated by the RBI in 2018 1 ) is much higher than the estimated tax cut impact on the GDP (as per Nobel Laureate Economist Abhijit Banerjee 2) , the impact of lower spending with the current macroeconomic headwinds would be cascading. Since lower collection will affect transfers to states, their finances would also come under pressure. As states are a 42-per-cent-party to GTR according to the 14th FC formula (Corporate tax is part of divisible pool and 42 per cent of it belongs to the states), they will together bear nearly Rs 60,000 crore of this revenue loss. This occurs when the following data shows the prevailing conditions at state level.

Source: Ministry of Finance – As published in Business Standard

This would also curtail the ability of states to expend (they have a revenue expenditure multiplier of 0.82 which would further cause economic stress). The bond market witnessed a heightened 10 year yield rate; which can be controlled by open market operations with injection of liquidity but such interventions by the RBI can potentially become incompatible with its inflation-targeting mandate. A higher general government deficit will impede transmission of its monetary policy. RBI has already been purchasing government securities worth 3.5 trillion rupees in the past 18 months and with the government set to ask for an even higher dividend transfer this year owing to fiscal woes, what may be worrying is the RBI resorting to print and spend cycle.

The best way to boost the economy?

The debate of the corporate tax rate cut vs direct capital infusion by the government to boost the economy (given the different multiplier rates) would be a topic of contention amongst various economists. But all we can hope for now is that the slew pf measure by the government aided by the rate cut would pull the economy from its slowdown and usher a time of growth.

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