Will the Corporate Tax Cut Boost the Economy?

Even though most businesses in the US benefit from a tax cut, in India it would affect only 1% of businesses since the latter is dominated by the unorganised sector with low incomes.

September 20, 2019, saw the highest rise in the Indian stock market in a decade because the government announced a big tax cut for the corporate sector. This was a clear response to the flood of bad news about the India’s declining economy.

It was also the seventh policy announcement since August 23 – the first six hardly made an impact on sentiments or the stock markets, and bad news continued to pour in.

The government then decided to make the seventh a mega announcement to boost business sentiment and please the stock markets. It was also designed to be a signal for foreign investors a day before Prime Minster Narendra Modi was to leave for the US.

Will the move have the desired impact on the economy?

False parallels

The tax concession to businesses will lead to an increase in their current post-tax profits. No wonder the stock market reacted euphorically. The government expects this to lead to an increase in demand in the economy and the end of the prevailing recessionary conditions.

A parallel is drawn with the US where President Donald Trump cut tax rates, boosting the US economy.

But the Indian economy is very different from the US economy or other developed economies. Those economies are largely in the organised sector and their taxation threshold begins at a fraction of the country’s per capita income, which puts most businesses in the tax net.

Also read: No Plans To Revise Fiscal Deficit Target or Cut Spending Now, Says Nirmala Sitharaman

India is dominated by the unorganised sector with low incomes and the taxation begins at about four times the country’s per capita income. Thus, a vast majority of businesses earn incomes below the taxable limit. That’s why a tax cut benefits all businesses in the US, but in India it would benefit only about 1% of businesses.

The stock market has a few thousand companies registered. These are controlled by less than 1% of the population. The wealth effect of a rise in stock market benefits only a tiny fraction of the population. These are the wealthy and their consumption hardly changes with their incomes, so they are unlikely to increase their consumption.

Those, especially from the middle classes who have invested in mutual funds etc, will also benefit, but by small amounts so any increase in consumption by these people will be small compared to the size of the economy.

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

Would the additional money accruing to the businesses be invested in creating capacity? If that were to happen, demand would rise. Unfortunately, creation of new capacity depends on increase in demand. Many big companies have been sitting on cash rather than investing.

If company A can produce 100 cars but it is only selling 70, then why would it invest in creating further capacity for producing another 20 cars? If it were to do so, its spare capacity would rise to 50 and profitability would be further hit. Most of the extra profit generated due to the tax cut would not lead to an increase in demand. Anyway, investment decisions are made in the long run and their impact would not be immediate.

Some have argued that companies could give more bonus to their workers or not retrench workers as has been happening. It is said that this would boost demand in the festive season. But if capacity utilisation remains low, retrenchment would continue. Contract workers were the first to face unemployment and now VRS is being offered to the permanent staff as well.

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As long as capacity utilisation continues to be low, businesses will act cautiously and hold on to reserves rather than give bonuses or employ more people. For the same reason, companies are unlikely to give greater discounts to consumers since they have already given what they could before the start of the festive season. And they have noticed that in spite of the large discounts, demand has continued to fall.

Given the uncertainty, increased discounts are unlikely.

Fiscal deficit

The government has said that it would forego revenue of Rs 1.45 lakh crore due to the tax cuts. Presumably, this takes into account the earlier concessions, like to the auto sector and to institutional investors. But it does not account for the Rs 70,000 crore of recapitalisation of the banks or the Rs 50,000 crore of incentive to exports or the Rs 20,000 crore fund for finishing houses.

Thus, the implication is that the fiscal deficit would rise by Rs 2.85 lakh crore. This is assuming that there would be no budgetary implications of other proposals like, easing of foreign direct investment (FDI) norms or help to MSMEs or an accelerated refund of GST.

The fiscal deficit would also be higher than the budget estimates since the estimation was done on the incorrect data on revised estimates of the previous year. Last year showed a short fall of Rs 1.6 lakh crore compared to the estimate used in the budget. So, to fulfill the target this year, the tax collection would have to rise by about 25% while it is rising by about 5%. Thus, there is likely to be a shortfall of revenue by at least Rs 1.6 lakh crore over the budget estimate.

Further, the budget is based on the assumption of a 12% rate of growth of the economy but it is barely growing at about 8%. Since the economy is still in a downslide and even if it grows at 8%, there would be a further short fall in revenue of Rs.44,000 crore. Apart from the additional Rs 60,000 crore from the Reserve Bank of India, no additional resources are in sight.

Thus, adding all this together, the fiscal deficit would rise by about Rs 4.3 lakh crore.

Also read: ‘Panic Reaction’: Modi Government’s Corporate Tax Cut Invites Opposition Ire

But, 42% of the revenue collected goes to the states. So, with the revenue loss due to tax cuts, short fall of revenue due to over estimation of revenue due to incorrect assumptions last year and shortfall of revenue due to slower growth of the economy, the Centre would lose 58%,

The Centre’s revenue loss would be about Rs 2.1 lakh crore and states would lose about Rs 1.4 lakh crore. The Centre’s fiscal deficit would rise by Rs.2.1 lakh crore plus the additional expenditures announced. Adding this to the Rs 7.04 lakh crore fiscal deficit shown in the budget, the figure would rise to about Rs 10.5 lakh crore. The states’ fiscal deficit would rise by Rs 1.4 lakh crore.

Additionally, since the growth rate assumed is incorrect, the GDP, instead of being Rs 211 lakh crore as assumed in the budget, would be Rs 200 lakh crore. The implication is that the fiscal deficit shown in the budget as 3.3% would turn out to be 5.3% of GDP. If the deficit is pushed on to the public sector and the state governments are added up, the total would be around 11.5%.

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The implication is that in spite of the increased level of deficit in the budget, demand would not be boosted by concessions to corporates. The problem did not originate in low levels of profits but in demand being short from the unorganised sectors. The low level of profits are a result of shortage of demand and lower level of production. Raising the level of profits would hardly increase demand, as argued above.

If the additional 2.3% of GDP had been spent on the unorganised sectors – farmers, workers under MGNREGS and cottage sector – and on social infrastructure, especially in rural areas, demand would have perked up leading to higher capacity utilisation, profits and investment.

All this begs a question: why has the government not done what was more desirable with the resources made available by the higher fiscal deficit?

Arun Kumar is Malcolm Adiseshiah Chair Professor at the Institute of Social Sciences, and author of Indian Economy since Independence: Persisting Colonial Disruption,2013, Vision Books.