Finance Minister, Nirmala Sitharaman’s Tax Cuts: Implications

On 20th Sept, 2019, Indian Finance Minister (FM), Nirmala Sitharaman, stunned the world with a massive cut in corporate tax rates, sacrificing 1.45 lakh crores, in taxes, for FY20, unsurprisingly, attracting a stock market salute, worth a 1930 point rise in the BSE Sensex Index (6% Rise) or about Rs. 2.1 lakh crores in investor wealth. Morgan Stanley, has upped the earnings forecast, for FY20, from 13% to 25% as this cut “boosts corporate savings”. Obviously, the following additional announcements aided the cheer

(a)Budget 2018-19 introduced, on investors, a 10% income tax on Dividend Income, over Rs. 10 Lakhs, over & above the DDT (Dividend Distribution Tax) of 20.56% (17.65% +12% Surcharge+4% Education Cess) charged on the company providing them an arbitrage opportunity vide corporate share buyback, a loophole foreclosed by the June 5^th 2019 Budget; the FM now revised the same, allowing company buybacks, without taxes, if public announcement was made before 5^th June’19.

(b)Surcharge increased from 15%, on personal income tax of payers, with gross income between 2-5 crores (30% basic rate+25% surcharge+4% Cess = 39%) & in excess of 5 crores (30% Basic rate+37%Surcharge+4% cess = 42.74%) respectively, introduced by the June 5^th 2019 budget, stood withdrawn, in Aug, to entice investors, back to the market; now enhanced surcharge shall also not apply to capital gains of any securities, including derivatives, in the hands of FPIs (Foreign Portfolio Investors)

The synopsis, of her announcements, is as follows:

(1)Option for “Domestic companies” to pay a reduced “corporate tax” of 25.17% (22% basic rate + 10% Surcharge + 4% Cess) from 34.32% (30% basic rate + 10% surcharge + 4% cess) if they stop availing of exemptions or incentives; Minimum Alternate Tax (MAT) is also waived.

(2)For corporates' seeking continuation of tax holiday/exemption period & the consequent incentives/exemptions thereof, tax rate slabs remains unchanged, but MAT has been reduced from 18.5% to 15%. Incidentally, all companies with an annual turnover of less than Rs. 400 crores fall into the 25% basic tax bracket while those above the threshold fall into the 30% basic rate slab.

(3)For domestic companies incorporated on or after 1^st Oct 2019, making fresh investments in manufacturing & starting production, before 31^st Mar 2023, Tax rate Is 17.17% (15% Basic rate + Surcharge +Cess) against 28.6%.(25%+Surcharge+ Cess).

Policy wonks, like Dr Arvind Virmani, have been advocating for some time the need for  India to announce a policy push to attract manufacturing supply chains from US & China, independently, by taking advantage of their trade spat, perhaps, a once in a generation opportunity, to increase the contribution of Manufacturing from 15% of GDP to 25% & creation of jobs thereof. Unfortunately, the delay, from the Indian bureaucracy & perhaps political will too, prompted supply chains to shift from China to neighbouring Vietnam- which boasts of quick decision making under a communist regime apart from a corporate tax rate of 20%. Vietnam’s exports, as a percentage of Indian exports, were 6% in 1960, 34% in 2000 & 75% in 2018 & could outstrip India in a few years. The FMs announcements, is a case of thus repenting at leisure.

Deployment of Higher Earnings

There are 5 possible alternatives available to companies for deployment of higher earnings consequent to the Tax cuts

(a)Reduce debt: which would help in alleviating the “Twin Balance sheet problem”. This would help restore health of the financial sector. But flight of capitalists like Vijay Mallya, Nirav Modi etc. does not inspire confidence.

(b)Fresh investments: is what the FM is banking on.

With capacity utilization rates in Indian Industry at 76.1%, in Q4 FY19 (RBI Report), investment might not pick up immediately especially when domestic corporates are burdened with high debts & Banks are suffering from NPA’s leading to the “Twin Balance sheet problem” – a term coined by the former Chief Economic Advisor, Arvind Subramanian. Expecting, therefore, Industry to start investing immediately is utopia for investments decisions are unlikely to be contemplated unless utilization picks up to about 85% which appears unlikely for the next 2 years since Indian consumption story has been weakening, courtesy the highest unemployment rate of 6.1% (as per NSSO-National Sample Survey Organization) during the last 45 years. Concede that utilization could vary across industry verticals but companies with high utilization levels might prefer scooping cheaper assets available under Insolvency & Bankruptcy code (IBC) to the alternative of green-field investments. Companies with high utilization & with no assets available vide IBC, & enjoying healthy financials would have invested even without the Tax cuts. That leaves only international manufacturing chains, looking for an alternative to China, to be welcomed.

US President Trump, announced a reduction in Federal corporate tax rate in the US to 21% (State corporate Tax is another 4% totaling 25%) from 35%, in Dec 2017, which led to $92 billion drop in corporate taxes (31% drop), in 2018.  An IMF (International Monetary Fund) study, on its effects, has arrived at the following conclusions

(b1)Only 20% of the increased cash, of corporates, flowed into investments & R&D; rest utilized for issuing dividends, share buybacks, asset liability & balance sheet adjustments. Thus it was more of a shareholder windfall.

(b2)Historically, in US, impact of tax cuts on investments peaks during the 1^st year after announcement but in the current case, is muted, due to policy uncertainty (Tariff hikes, Trade & Economic policy) & greater corporate marketing power.

(b3)Reduction in personal income tax & government stimulus boosted aggregate demand & contributed more to increased investments than corporate tax cuts. Indian policy makers should have taken a cue & a demand side policy initiative would have been more prudent.

(b4)Non- residential investments, in equipment, software & IP, were significant while residential investment was below projections.

(b5)Cost of capital drop vide corporate tax cut had insignificant impact on investments.

(c)Increased wages: to employees spurring consumption.

The wage revision for the current year was announced in July, for most companies, & the next revision is due more than 9 months away nullifying any expectation of increased wages in the interim. Would companies issue a “Diwali bonus” is anybody’s guess

(d)Increase discounts: to customers.

This is likely during the impending festival season; UR Bhatt, MD of Dalton Capital advisors, averred that “unless there is demand generation, there might not be new investors, irrespective of the tax cut”.

(e)Pass on earnings to investors: possible, looking at the US experience

Fiscal Maths

An unfortunate, immediate, outcome is an increase in fiscal deficit by 0.7% (0.45% after netting off the states' share) unless the govt. recoups losses vide

(1)Non tax revenues with strategic sales / divestment of PSU (Public Sector Units). The withdrawal of surcharges on personal tax surcharges, announced in the June 2019 budget, is thus meant to attract both FPI (Foreign Portfolio Investors) & domestic HNI (High Net worth Individuals) back to the markets, to gain better valuations.
(2)PSUs transfer the increased earnings as additional dividends to the government
(4)Non Govt companies transferring additional earnings vide dividends & hence a higher DDT inflow to government
(4)Stock market rise & profit booking attracting increased revenue inflow vide LTCG (Long Term Capital Gains)

Despite all of the above, the ‘off balance sheet” financing, resorted to by the government, means that even the current fiscal deficit no. of 3.3% is understated & the ambitious revenue projections for FY20 without incorporating the Rs 1.7 lakh crore revenue dip last year – as alluded to by Rathin Roy of the Prime Minister Economic Advisory Council – means that the fiscal deficit would go for a toss even if there is an expenditure compression. No wonder, while the stock market is celebrating, the bond market has seen yields rise, expecting a rise in government borrowing.Lower transfers to the states would lead to deterioration of the state's finances & increase in the states' deficits too.

Generally, monetary easing - leading to lower interest rates - is complemented by fiscal conservatism - vide control on deficits or vice versa. The government & the RBI have opened up both the taps now as a strategy to revive growth; managing an external shock, therefore, would not be easy.

Investment rush unlikely

India might not be able to replicate the US experience of investments, historically, peaking within 1 year of corporate tax reductions, due to low industry utilization rate of 76.1%; International investors could take 12 - 24 months to get their proposals approved by their boards & the famed Indian bureaucracy known more for “Red Tape” rather than “Red Carpet”. If India signs the Regional Comprehensive economic partnership (RCEP) - a trade agreement that includes ASEAN & China too – there might be a lesser incentive to trudge in.

Modi, as usual, has timed this announcement to coincide with the “Howdy Modi” event in the US & his expected meetings with the captains of American Industry. Prudent that the Govt. stop making fresh “reform” announcements every Fri - a practice seen during the last 1 month – which could unwittingly incentivize even interested investors to adopt a “wait & watch mode”, salivating at more giveaways.

Conclusion

The reduction in corporate tax rates would lead to additional demands on releasing the Direct Tax code for consultation on personal income tax reduction too; all Finance Ministers want to play God on Budget day & a DTC law, if implemented, would reduce their importance just as the GST law & the establishment of the GST council - of which state Finance Ministers are members too - has forced them to share power, hemming in the likelihood of the Centre taking independent initiatives on Indirect taxes. Therefore, they would delay releasing a discussion paper on DTC, unless it becomes absolutely inevitable.

India is the 3^rd largest country in PPP (Purchasing Power Parity) terms & predicted to  overtake the population of China by 2027 – as per a UN (United Nations) report & hence the interest of manufacturing companies to invest in the country with the largest potential consumer market in the world is unexceptionable. While India is about 20% of China’s GDP in absolute terms, it is 42% in PPP terms buttressing the assessment. However, expecting them to rush-in, is foolhardy as India has a reputation for introducing retrospective taxation (Ex.Vodafone case) & cesses over & above the basic rates, impairing carefully set plans. The economic scenario in India for the next 12 months would thus remain grim while the exuberance of the stock market shall persist sucking in unsuspecting retail investors."Acche Din" are perhaps 18-24 months away.