Two paths after a major tax cut in India

The announcement of a corporate tax reduction aimed at reigniting a stuttering Indian economy has taken the country’s stock markets to their highest point in a decade and strengthened the rupee against the dollar. It will also boost corporate profits at a time when growth has fallen to its lowest point in recent years dragging the country down from its fastest growing major economy status.

Thematically, the measures announced are geared towards giving struggling Indian companies, especially in battered sectors like automobile, some breathing room, and encourage them to propel into a virtuous cycle of investment and growth. Among the schemes announced is allowing companies to use mandatory corporate social responsibility (CSR) funds in bankrolling public sector educational institutions and incubators. The new tax rates make the Indian market highly competitive, in taxation terms, with comparable economies in Asia. For India Inc., which has been complaining about ‘tax terrorism’ for some time now, these new tax rates are a balm.

Whether these initiatives can deliver the much-needed upsurge in the Indian economy will be known in a few financial quarters, but it is pertinent to point out that they come at a time when capacity utilisation in Indian business has slowly crawled to its highest since 2016 to just above 76%. In July 2016, it was just under 72%. But both industrial production and manufacturing production are far from their peak levels.

If India Inc. takes the additional cash that the tax cut would free up and invests it expeditiously, the economy could turn in a relatively short period. If CSR funds are used judiciously to bridge innovation gaps especially in public sector education, this could well be a game changer. One example of remarkable work in this area is the millions of dollars Azim Premji has spent and is spending in boosting education capacity in rural government schools across India. It is an example worth emulating.

This virtuous direction is the best-case scenario of these tax cuts and no doubt the government would be hoping that this is the route these would unfold. There is though another way that this tax cut could swing. That has to do with the nature of the Indian economic slowdown. What exactly is the problem in the Indian economy? One is a liquidity issue caused by years, some say decades, of poor-quality loans given by banks which has caused a near collapse in the lending structure of Indian banking. A lot of this has to do with malevolent political pressure in the past on public sector banks to lend to spurious projects that were designed to loot, not build. The other (some would argue that this is at the moment the more critical problem) is the fall in demand. Simply put, the Indian consumer does not want to spend. This is most obvious in two key sectors: automobiles and real estate.

How can demand be boosted? It is difficult because demand is built on sentiment, and that sentiment has soured in India not least because tens of thousands of Indians spent their life savings in buying homes—to take an example—in the last decade which have never been delivered and despite promises no concrete solution has emerged in most cases. In automobiles, it is easy to see why the Indian consumer who mostly lives in cities and towns choked to death by traffic might be reluctant to spend more money on substandard cars that Indian auto companies mainly produce. Many of these, in fact most of these, would not pass crash tests in developed countries.

Also, there has been an overall dampening of Indian demand—a record number of the country’s millionaires have moved overseas—and people feel that the ‘climate’ is not conducive in the country. According to the Global Wealth Migration Review by AfrAsia Bank, and New World Wealth, a research firm, around 5,000 high-net-worth individuals (HNIs) left the country in 2018, a number that amounts to 2% of the total HNIs in the country. It is very hard to decipher the exact reasons for this sentiment but its effect on the economy is clearly felt. One example of sentiment is illustrative: In education, large numbers of students continue to leave India for higher studies as year after year Indian universities make zero impact in global rankings. The knowledge edifice of India, always tottering, now seems inundated with artificial noise, the evil twin of artificial intelligence.

This can be changed if the companies who have received this big tax break pass the benefits onto the customer, bring down prices (the real estate sector for instance continues to be artificially inflated by dirty money), give hefty discounts and pass-on an overall sense of benefit to the beleaguered customer.

The question is, would they? Naysayers would point out that it is possible that the groups that benefit from the tax break would work to hoard the savings, even transmit them overseas, leading to a rise in asset prices and not necessarily working as a demand stimulus. It is worth noting that taxation is not the only reason that has made India uncompetitive, and that infrastructure spend probably has a higher demand multiplier than a corporate tax cut.

No wonder then that the talk on the street has moved immediately to the next step to fuel demand—a cut in income tax. That may well be needed before any mass ripple effect on demand and growth is palpable. But note that there is only so much tax that the government can sacrifice especially since significant holes in tax collections have appeared and Prime Minister Narendra Modi has an ambitious (and welcome) target in delivering governance goods in critical areas like supplying tap water to every household, which need funds.

There are two ways this tax break could take, and we would have to wait at least till the middle of next year to understand which way it went.