Reduction in corporate taxation: Booster or Band-aid?

On Friday, 20th Sep 19, Finance minister announced new array of measures to stimulate economy which is slowed down back to 2013-14 levels. This is second major announcement from finance ministry to put country back on growth path. First one was to inject ₹70,000 Cr in PSU Banks which was done in in Aug’19. With new announcement, finance minister Nirmala Sitharaman surprised everyone by cutting corporate tax from 30% to 22%. Many experts are saying this is the second biggest reform since 1992. Today’s AI post is a short note on the same. Let’s analyse its impact on the GDP. It will be a two point analysis where we will look into both positive and negative aspects with a conclusion.

Possible reason behind this decision

At times, it is tough to find out the reason behind government’s decisions as it is often based on economic-political factors. However, this one seems little straight forward and purely based on economic situation. Government is going to take a hit of ₹1.45 lakh crores by doing such a drastic change. Possible assumption behind this decision can be to revive private capex which is languishing at multi years low. In a way seems good decision as banks do not have enough money to fund new capex requirements, so instead of infusing more capital to banks, they directly gave money in hands of corporations.

Top 3 Positives

1 Corporate tax at 30% was pretty high across many developing nations where average is around 24%. In Asian region only Philippians has a similar tax structure with 30% tax on corporate earnings. With new tax structure, India has suddenly fallen below the Asian average taxation rate which is very encouraging for attracting foreign shops in India.

2 This is a massive reduction of almost 26% in taxation. So if hypothetically a company was paying 30% taxes on EBT of ₹100Cr which was ₹30Cr, leaving ₹70Cr as profit. Now it will have ₹78Cr as profit. This extra ₹8Cr translates into 11.4% more profit without any changes in operations.

3 Suddenly, Indian market which was at P/E of 26.3, appeared at a P/E of 23 of within few hours. Obviously, investor immediately lapped up this opportunity. Sensex shot up 5.3%, leaving hypothetically 8.5% more on the table for next week to reach at previous P/E levels. Since this announcement came on Friday afternoon during non-working hours of US investors, we can expect some more upside next week resulting from FII participation.

Top 3 Negatives

1 This is going to put strain on Government’s financial condition as ₹ 1.45 lakh crores is almost 5% of India’s budget expenditure. So, in a way 5% of announced schemes under last budget will not see a day of light. Also, this severely limits Government’s ability to announce new measures or policies to combat economic slowdown in future.

2 It is corporate and their owners who are going to get this immediate benefit. All CEOs are extremely happy and why not since it will help them to achieve their annual targets. Media is publishing their interviews and it is funny how suddenly these talking heads have turned from pessimistic to optimistic within a span of few hours. The key part is how much of this extra profit will trickle down in form of either new capex or price reduction. Chances of any of this happening is pretty bleak. Most likely, this extra money will get funneled into the pockets of corporate owners and their shareholders only. Large portion of Indian population, about 93% of them, who do not invest in equities will be left untouched by this move.

3 Even within corporations, it may not impact many organizations as their finance teams are using various exemptions to cut down effective interest rate below 20%. Take the case of India’s biggest company, Reliance Industries, it barely paid 18% effective tax rate in last year and Reliance is not alone. Most IT companies are also using various measures like SEZ etc to reduce their tax liability within 20-24% range. Such a move will also not impact them. Industries where it can have some impact, as they were in high taxation bracket will be steel, textile to some extent automobile, mining etc.

Our Take

There are two sides of the economy, supply & demand. Present move to reduce corporate tax is going to help supply side as companies are sellers of the goods & services in the economy. It does not mean much for demand side unless the seller plans to reduce prices and pass-on this benefit to consumers. It is an indirect way of stimulating the economy.

In our view, government could have taken direct steps by proving liquidity and money in the hands of demand which will automatically spur supply as well. With India’s overall industrial capacity utilization howering at 76%, we do not need fresh capex at the moment as there is still 24% left in the tank. Also, we are not sure how much of this money will actually trickle down from corporate’s balance sheet into the economy. It is at CFO’s mercy.

As per our analysis, the main reason behind current slowdown is clearly lack of demand. This lack of demand is emerging from a) changing consumption patterns in urban places, b) lack of income / savings in rural places. In India, agriculture, construction & manufacturing provides a major chuck of jobs. The blue collar workers from rural places are dependent on these industries which at the moment are all down simultaneously. While agriculture is a big bang issue which needs more of structural reforms, Government can focus on construction & manufacturing sectors to create livelihood opportunities. ₹1.45 lakh crores would enable a lot of public infra projects which are stuck due lack of funds.

Also, government has to do something with white elephants in our economic system. The AirIndia, PSU Banks & likes BSNL in the system. A bulk of revenue goes into bailing out these giants which is can be better utilized elsewhere. It has to be done in a planned manner to mitigate impact on government employees which can be a politically sensitive issue.

Overall, we are having a neutral stand on these supply side reforms as they are good to have but not must haves at the moment. When you are extremely hungry, you immediate concern should be main course not dessert.

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