Union finance minister Arun Jaitley has his work cut out for him. Not only is the government’s overall revenue target likely to slip, the international corporate tax environment is also changing radically, unlike any time in the recent past, placing tax competition front and centre on the international agenda. With the passage of the tax reform package in the US which has sharply brought down the peak corporate income tax (CIT) rate from a high 39.6% to a low 21%, tax competition will be another new worry furrowing the finance minister’s brow in 2018.
The US reform dramatically reduces tax rates across the board, particularly for businesses, and promises to greatly simplify tax laws. Apart from the new low CIT rate of 21%, it also repeals the corporate alternative minimum tax, and provides for an indefinite carryforward of losses.
The proposals relating to business income taxation have the potential to start a huge international tax war, as the low headline corporate tax rate may spark competitive rate reductions across the world. This could have tremendous consequences for the investment environment in emerging economies, particularly in India.
The table below shows existing corporate income tax rates in selected economies, from competitors to the US such as the UK and China, to other emerging economies, including the BRICS, which range between 20-35%. The Organisation for Economic Co-operation and Development (OECD) average rate is about 25%. The US rate of 21% would be one of the most attractive tax rates on corporate income amongst all major economies, and certainly among the sought-after investment destinations. Investment decisions of multinational enterprises with the ability to locate operations in a destination of their choosing will surely favour the US, if this tax plan is implemented.
The impact on developing countries with weak investment climates – such as India – who need to attract foreign direct investment to their shores can be severe. India already offers huge tax incentives to multinational companies in a bid to attract investors, losing much-needed tax revenues. If drawn into a competitive tax war, India may need to make further concessions if it is to offset the reductions in tax rates in the US, putting further pressure on tax revenues.
The consequences to the investment-GDP ratio in India could be significant. Already, the gross fixed capital formation statistic continues to decline year after year. It has come down from a high of 37% of GDP in 2007-08 to 28.9% for Q2 of 2017-18 (as per the CSO Press Release of November 30, 2017). The Centre for Monitoring the Indian Economy (CMIE) reports that new investment proposals are likely to stabilise around Rs 8 trillion in 2017-18 which, would be about 60% of the new proposals made during 2016-17 and would be the lowest level since 2004-05. This would be the third consecutive year of a fall in new investments since they spiked momentarily in 2014-15, the difference is that the fall in 2017-18 would be sharper than in earlier years. In this context, a sharp reduction in corporate tax rates in a large, attractive investment destination like the US could have a further negative impact on India’s competitiveness. The economic uncertainty to the investment climate in India caused by demonetisation and the shabby design and implementation of the Goods and Services Tax (GST) does not help.
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The consequences for tax revenues would also be significant. While the value-added tax (VAT) and other indirect taxes are now the mainstay of revenues in the OECD and developed countries, corporate income taxes still contribute over 30% to the total central government revenues in India. And if India is forced to cut corporate tax rates or offer huge tax sops to attract investment, corporate tax revenues will be hit. India already has a low tax-GDP ratio of around 16-17%, roughly half the OECD average of 34%.
The finance minister needs to begin to think of strategies to counter the negative impact of a tax war on business taxation. Perhaps he also needs to start thinking of alternative tax instruments which could be gainfully utilised to boost tax revenues.
First, he needs to improve the efficiency and effectiveness of the main indirect tax, the GST. India started out with an overly complex, poorly-designed GST, which has dampened investor sentiment and created tremendous compliance burdens on small and medium sized enterprises (SMEs). The administration on its part has found administering the GST a challenge, and ad hoc changes in the tax slabs applicable to commodities has not helped. The finance minister needs to announce a roadmap to a simpler, more efficient GST regime, with no more than three rate slabs and a high threshold so SMEs are spared the burden of complying with an onerous tax. Jaitley must also figure out how to help states build capacity to improve recovery and reduce the administrative burden on taxpayers. This will not only help improve the business climate but also lead to higher revenues.
Second, to revive the investment climate, the finance minister needs to do only one thing – act on his own promise made in his very first budget of 2015-16, i.e., that he will eliminate most tax incentives and put in place a flat 25% tax rate. (Perhaps now that the US will have a 21% rate, even a lower rate may need to be considered for India). Given that there exist a range of tax incentives, there is limited room to reduce the headline tax rate due to revenue considerations. The fact is, while the headline tax rate is 30%, with the various cesses and surcharges, the actual headline rate is 34.61%, or almost 35%. However, most large companies can employ the services of tax lawyers and accountants and – using the various tax incentives – get the tax liability down to close to the effective CIT rate of 23 or 24%. The end result? India gives out a signal of being a “high tax” economy, but ends up with low revenues owing to tax incentives.
Getting rid of tax incentives will also signal a level playing field to SMEs who are less able to employ tax professionals to help them plan their businesses in a way that helps them reduce their tax liabilities.
It is important to point out that tax incentives are hardly ever a guaranteed means to attract investment. To achieve that, the finance minister has to focus on real factors such as improving infrastructure, fixing the banks and ensuring India lives up to its image of an open, multicultural, secular, free democracy.
In case CIT reforms do lead to potential revenues losses, the finance minister needs to look at how revenues could be increased from other direct tax instruments, such as the personal income tax and the property tax. In India, personal income taxes constitute just about 2% of GDP, whereas the OECD average is 8.5% of GDP. Property tax is one of the least utilised tax instruments in the developing world, with India collecting less than even half a percent of GDP. There is potential to increase tax revenues here, given that countries like the UK and the US collect over 3% of GDP from this tax.
Another option is for the finance minister to focus more on excises. Some excises have positive externalities, apart from raising revenues: there are health gains to be had by increasing the taxation of tobacco products, for example, apart from greater tax revenues. Carbon taxes can increase revenues while limiting carbon emissions. Taxes on fuels also serve the same dual purpose.
Rajul Awasthi works for the World Bank on tax reforms. Views are personal.