Corporate tax cut wrong prescription for India’s economic woes

A patient goes to the doctor for treatment of malnutrition. But the doctor prescribes him medicines for lack of appetite. In a similar act, when the Indian economy is suffering from lack of demand and consumer confidence, the government has given a massive corporate tax cut dose to enhance industry confidence.

“All these measures are supply-side interventions and the economy is facing demand-related challenges. They might have a medium-to-long-term impact, but it is too early to comment,” said Devendra Kumar Pant, chief economist at India Ratings.

Due to dwindling disposable incomes, job losses and lack of confidence in the future prospects, there is a synchronised slowdown in consumption of all items across the board. Consumers have stopped buying big-ticket items like homes, cars, two-wheelers, furniture, smartphones, etc. Consumers have also considerably reduced on consumption of daily staples like packaged foods, soaps, clothes, etc. For want of sufficient demand, present capacity utilisation of industry is less than 80 percent.

The most direct and effective ways to spur consumption demand in the economy is (1) by reducing the prices of products through across-the-board GST cuts, (2) by increasing the disposable incomes of people through reduction in personal income tax rates and (3) by enhancing the confidence levels of people through job creation and increased government spending on infrastructure.

Instead of opting for any of the above demand-side interventions, the government has chosen to enhance the confidence of the corporate sector through massive tax cuts of ₹1.45 lakh crore to them. Before the cuts, the rate of effective corporate tax rate (after availing exemptions) in India was about 30 percent. This is 5 percent higher than China but equal to or lower than the effective tax rate prevailing in most of the advanced economies of West.

There is no doubt that the effective corporate tax rate of 30.45 percent paid in 2019 is higher than most Asian countries and deserves a reduction. But there are doubts about the government’s ability to provide fiscal stimulus, considering the fact that government finances hardly inspire confidence.

India’s fiscal deficit touched ₹5.47 lakh crore in June quarter, which is 77.8 percent of the budget estimate for FY 2019-20, as tax collections have remained muted. With the corporate tax cuts, the fiscal deficit target of 3.3 percent will shoot up to 4.1 percent. So, the government should have utilised the scarce fiscal space available with it for more pressing needs rather than to splurge on the corporate sector.

The shock and awe corporate tax cuts effected by the government are beyond the wildest dreams of corporate tycoons. The government has slashed the corporate tax rate from 30 percent to 22 percent for all companies. Inclusive of cess and surcharges, the effective corporate tax rate in India now comes down to 25.17 percent. Newer companies, which are set up after October 1, 2019, will be subjected to an even lower effective tax rate of 17 percent (15 percent + cess and surcharge). On average, the corporate sector is likely to save a fourth of their tax outgo. What will happen to this additional money accruing to the corporate sector?

Companies in some badly affected sectors may pass on a part of this largesse to consumers through price reductions. But companies in sectors where demand is near to available capacity may not effect any price reductions. Most of the corporate sector's pricing formula is based on their EBIDTA (Earnings before interest, depreciation, and taxes) margins and not on their PAT (Profit after Tax) margins. Hence the trickle-down effect will be marginal and time-consuming to immediately spur consumption demand in the economy.

There are some experts who believe that lowering of corporate tax rate could raise consumption demand through what is called the ‘wealth effect’. ‘Wealth effect’ is a behavioral economic phenomenon where consumers start spending more because of greater confidence driven by higher values of their financial and physical assets. For example, households may feel richer if the portfolio value of their equity investment or real estate rise quickly and spend more, even though their regular incomes have remained the same. The announcement of the corporate tax cut has indeed improved the sentiment in the stock markets in the short term and Sensex has zoomed by 2,000 points. 'Wealth effect' will play out to spur consumer demand, only when people believe that the rise in values of their investments is durable. In a fragile economy, it is likely that people may feel that the rise in their wealth is a temporary blip and may not spend more. 'Wealth Effect' is also limited to only 10 percent of India's population who hold considerable assets. It will not have any effect on the rest of the 90 percent people.

We are back to the original issue. What will happen to this additional money accruing to the corporate sector? The corporate sector distributes about 25 percent of their PAT as dividends. Along with the promoters, one crore of minority shareholders will get more dividends. This additional money distributed to shareholders is more likely to be reinvested in equity and bond markets and mutual funds, rather than being spent on consumption. So capital markets may get a boost, but not the economy.

After dividend distribution, balance savings left with the corporate sector can be utilised either for reduction of bank loans and/or capital expenditure. Considering that the present capacity utilisation is low and there is no hope of immediate pick up in consumption demand, corporate sector may not undertake any huge capital expenditure programmes for expansions or greenfield projects. A major part of the corporate tax giveaway of ₹1.45 lakh crore will occur to the large 100 companies earning large profits. They may use some of this money to take over PSUs or Public Sector Banks likely to be privatized by the government. That’s how a part of the money may come back to the government through disinvestment.

(V Venkateswara Rao is a retired finance professional and a freelance writer).