Corporate tax reduction was long overdue, but it is not a magic pill

A lower tax rate only marginally tilts the scale in case of unviable projects by increasing the post-tax RoE but it cannot materially alter the viability of a project. This is not to say that tax rate is irrelevant, just that other factors can overwhelm it, especially in the short-term.

The other way the lower taxes could work themselves through the economy is if companies pass on the benefit of lower taxes to their consumers through lower prices and this stimulates demand. This is plausible, but if this was the government’s intention, it was better achieved through lower indirect taxes since there is a much stronger correlation between lower taxes and lower prices in the case of indirect taxes than it is in the case of direct taxes. That said, the fact that this measure by itself may not revive investments or demand in the economy does not, by itself, take away from the merits of this decision.

As discussed above, the corporate tax rate in India was high and the government has attempted to correct it. It, at the margin, encourages the corporate form of doing business and thus formalisation and it also makes India a more attractive destination for investment by overseas companies than before. At the margin it also tilts the balance in case of some projects that otherwise would not have happened. That is welcome. The recent announcements should thus be looked upon as ‘necessary but not sufficient’.

The other question that arises is whether the course of action the government has chosen to reduce the tax rate was the best possible method. The most obvious point is that the biggest distortion in corporate tax structure was the triple taxation of dividends (which is a way of returning excess profits back to owners) and the way to reduce this distortion was through elimination or reduction of dividend distribution tax rather than headline corporate tax. A lower burden of tax coupled with reduced or elimination of distortion is preferable to just a reduced burden of the tax.

The second issue is that the reduction of tax rate disproportionately favours large corporates and reduces the progressiveness of corporate tax (headline corporate tax rate for smaller companies was already at 25 percent). It would have been better to maintain the progressiveness of corporate tax by reducing the tax rate for smaller companies even more or reducing the quantum of tax reduction for the bigger companies. It is the smaller businesses that have a larger propensity to invest and employ relative to bigger companies.

A related issue is a perverse incentive that the lower tax rate (17 percent from the current 28.6 percent, before surcharges and cess) for new manufacturing companies creates. It incentivises shifting of newer manufacturing capacity of even existing companies into dedicated SPVs – whereas the intention of the lower tax rate is to attract brand new investment that otherwise would not have happened or at least tip the balance in case of some fence-sitter investments. This in a sense is the collateral, but inevitable, fiscal cost of this change.

The final issue for me is the cost of this ‘reform’. As per the government’s calculations, this tax reduction will cost around $20 billion which is around 0.7 percent of GDP – 0.4 percent of GDP to the central government and 0.3 percent of GDP to the state governments. What was left unsaid yesterday was how would this gap be filled given that the government is already staring at lower tax revenues even adjusting for the higher dividend from the RBI. Would the government cut back on expenditure in a major way to meet the deficit target or has the government given up on the fiscal deficit target? If the government must cut back sharply on expenditure then it would be negative for growth, relative to the expectation prior to yesterday, at least in the short run. And if the government were to abandon the fiscal deficit target altogether, it raises the prospects of higher inflation and interest rates and crowding out. And while many will argue that fiscal deficit is an abstract concept, lest we forget, we are an emerging market economy highly dependent on capital flows. And capital flows are fickle. For what it’s worth, the domestic bond markets have already sounded an alarm bell yesterday.

Lastly, policy makers should try and avoid the policy mistake of 2008-09. The policy mistake of 2008-09 was an outsized fiscal and monetary stimulus (and its delayed withdrawal) to the economy in response to a slowdown. The context today is, of course, different, but with the government having taken the fiscal route to boost the economy, it is time for monetary policy to become cautious. It is time for MPC members to have a hard discussion with the government over its fiscal strategy before taking a call on policy rate a couple of weeks down the line. The impact of any stimulus, fiscal or monetary, will be visible only after a lag. And so, caution needs to be exercised before continuing down the path of more stimulus. As our own experience shows, there can be something called ‘excessive stimulus’ with real costs.

To conclude, there is no doubt that a lowering of corporate taxes in India was long overdue. The only question is over the manner and timing. As they say, there is no ‘easy’ reform. For if there were one, it wouldn’t have taken this long for that reform to be done. Markets are currently focussing on the positive aspect of the reform. But there is a flipside also with respect to the government finances and its impact on other macro variables including growth itself. There will be a time markets will need to focus on that too…