Explainer: Will Nirmala Sitharaman’s Corporate Tax Cuts Save India's Economy?

What does this mean for India’s fiscal deficit target? The Wire breaks it down.

In an effort to boost the economy’s waning spirits, finance minister Nirmala Sitharaman on Friday cut corporate tax rates and offered a host of tweaks that will reduce India Inc’s financial burden.

The cost of providing such relief? A whopping Rs 1.45 lakh crore in revenue that the Centre will forego in the hopes that this will revive investment and expand the corporate tax base.

But will this help all major companies and if so, will it help immediately? And what does this mean for India’s fiscal deficit target? The Wire breaks it down.

How much of a cut in corporate tax rates are we looking at?

The subject of how much tax India’s companies pay is complicated and messy. The problem is that there’s no such thing as ‘one’ corporate tax rate in India. 

Over the last decade, the official corporate tax rate (also called ‘headline’ or ‘statutory’ rate) has come down from roughly 35% to 30%. 

The problem, however, is that we have a vast and complex system of exemptions that reduce the statutory tax rate. This list of exemptions can be found here, under the government’s statement of tax revenue foregone.

On top of this, there are surcharges or levies which also effectively add to the statutory tax rate.

These exemptions and surcharges thus produce what is called an ‘effective tax rate’ – what a company pays after taking into account the factors that reduce or add to its tax burden.

This means that different industries have different ‘effective tax rates’; there is sometimes variation even within the same sector. A 2016 analysis by the finance ministry – which is now slightly outdated, but still proves the broader point – showed that the effective tax rate for manufacturing companies was 24.75%, while for service companies it as high at 28.73%.

Generally speaking, capital-intensive industries (such as power or petroleum) often have lower effective tax rates.

Also read: Data Shows Largest Firms Benefited Most From India’s Corporate Tax Cuts

There are two main takeaways here. 

Firstly, Sitharaman has reduced statutory corporate tax rates from 30% to 22%. This ‘22%’ is actually 25.17%, after adding surcharges and levies. But, because effective tax rates vary from sector to sector, this reduction doesn’t have the same effect across India Inc. For some companies (like auto firms or banks) the relief is greater, while for others it’s lesser.

If you’re a stock market investor, here’s a good compilation of listed companies that have an effective tax rate greater than 25% and will benefit from the move.

Secondly, Sitharaman has introduced what is a dual-track system of taxation. In her press conference, she noted that the 22% tax rate would apply only to domestic companies that chose not to avail of the various exemptions that are available to them. This means companies can choose to avail of the lower 22% rate or choose to stick with what they have and keep the exemptions.

Will these tax cuts have an effect on new investment?

The other major tax announcement that Sitharaman made was that new manufacturing companies, which start operations after October 1, 2019, will only have to pay an even lower corporate tax rate of 15%.

New manufacturing companies will have to pay an even lower corporate tax rate of 15%, which translates to a little over 17% after taking into account levies and surcharge.

This is a major step in terms of attracting new investment. Foreign companies wanting to relocate to India with fresh investment will pay only 15% corporate tax now. At a time when the US-China trade war is making multinational companies re-think their investment strategies, this is a huge incentive for global companies to come to India. This also puts the Indian tax regime at the same level as many East Asian countries including Singapore. 

On the other hand, more clarification is needed, as The Wire’s M.K Venu has pointed out. Does the 15% tax rate for new manufacturing companies also apply to the existing corporations that decide to launch new investments with their subsidiaries? And if so, will this undermine the move to lower the headline corporate tax rate from 30% to 22%? 

Will it perk up India Inc, which has been feeling gloomy over the last few months?

India’s stock markets are in rapture. The 30-share benchmark Sensex is up by over 1,800 points, the biggest single-day gain in over a decade.

This is also the first big, non-incremental tax reform by Narendra Modi government in five years. Most analysts expect that corporate earnings will improve by 10% to 15% in the next year, especially for those companies that don’t avail of too many exemptions. This should improve business sentiment and hopefully help the Indian economy attract new investment.

By announcing a reduction, Nirmala Sitharaman is also fulfilling a promise made by Arun Jaitley back in 2015-16. In that year’s budget speech, the late BJP leader vowed that the Narendra Modi government would reduce the corporate tax rate of 30% to 25% in phases.

Will it reverse the economic slowdown and set right India’s growth trajectory?

This is less clear. India’s economy currently has a problem on the demand-side – consumers are reluctant to buy everything from biscuits to cars. 

Reducing taxes, which boosts corporate earnings, doesn’t automatically solve this issue, unless companies pass on the benefit in the form of reduced prices. It’s not clear that will happen.

Former chief statistician Pronab Sen has noted that this is a “supply-side measure” and is unlikely to help in the short-term as the wealth effect doesn’t really count in a country like India. Reviving demand is a medium-term project that requires essentially putting more money in the hands of India’s consumers. 

How will this affect India’s fiscal deficit?

This is Nirmala Sitharaman’s gamble in a nutshell. The finance minister noted that the tax cuts will result in a Rs 1.45 lakh crore loss to the exchequer in 2019-20. Even with the generous Rs 1.75 lakh crore transfer from the RBI earlier this year, initial estimates say that the country’s fiscal deficit will likely surge by at least 70 basis points to 4% of GDP in 2019-20 as a direct consequence of this move. This will have implications for our standing in the eyes of global rating agencies.

On the other hand, Modi and Sitharaman are betting that by bringing in more investment and boosting government revenue, this will help repair any damage done to the country’s fiscal situation in the long run.