India and the world at large are going through an economic slowdown. Many economists opine that a recession is imminent. Major economies of the world are facing sluggish consumption demand and India is no exception. Automobile and real estate sectors have been badly hit. GDP growth rate for the first quarter of the fiscal year 2019-2020 has been reported to be 5 per cent; the lowest in six years. There are claims that the actual growth rate may be around 2-4 per cent only, which raises concerns even more. In light of such an economic crisis, Finance Minister Nirmala Sitharaman announced the biggest ever tax cut for the corporate sector in 28 years, slashing the tax rate from 30 per cent to 22 per cent. For new manufacturing companies, the tax rates have been slashed to 15 per cent. On one hand, the move has been hailed but on the other it has been criticised.
Expansionary fiscal policy
In times of economic slowdown, the government either resorts to expanding the fiscal or monetary policy to boost growth. Where the monetary policy aims at increasing money supply in the market, the fiscal policy intends to raise aggregate output in the economy by raising government expenditure and reducing tax rates. In such cases, the government spends more than it earns as tax revenue. In the current scenario, the tax cut is supposed to increase profits after tax deduction for the corporate sector so that they can invest that surplus fund and generate higher incomes with a multiplier effect. Moreover, the corporates are expected to pass down the benefit of the tax cut to the customer by reducing the cost of products.
Rationale behind slashing corporate tax
In times when consumption undoubtedly is the root cause of slowdown, the government has decided to go for boosting supply while at the same time reducing corporate tax. The benefits of such a move reflect only after a particular span of time but are beneficial in the long run. Many questions arise as to why the government did not do anything to raise the disposable income of people or to make consumer goods cheaper. This move is in line with the trend in developed nations such as USA and UK where corporate tax rates are way below personal income tax rates to boost manufacturing and service sectors. Slashing personal income tax rates and GST slabs would have left consumers with more money in hand and thus, would have resulted in increased aggregate demand. One needs to understand that income tax is paid by around 1 per cent of the people only since the tax base is not wide enough, whereas, around 60 per cent of direct tax revenue comes from corporate tax. So, a move of reducing income tax would not have brought about the needed effect. It should also be noted that jobs are not created by reducing personal income tax but by cutting corporate tax rates. Also, changing GST tax slabs requires consensus amongst all state governments in the GST Council which is a cumbersome task.
In the discipline of Economics, increase in investment and reduction in tax leads to an increase in income at a multiplied rate. Hence, the two measures have a multiplier effect. Whereas the former has a positive multiplier value because of a positive relationship between investment and GDP, the latter has a negative multiplier value due to an inverse relationship between tax rate and GDP. Sukanya Bose and NR Bhanumuthy estimate the value of tax multiplier at around -1 in their research paper ‘Fiscal Multipliers for India’, which was published in September 2013. This implies that a tax cut of, let’s say, 100 crore rupees will raise the level of GDP in that fiscal year by 100 crore rupees; given both the figures are measured at nominal prices.
Boost to Make in India
The new tax rate brings India at par with other South East Asian countries. Singapore (17 per cent), Vietnam, Thailand, Taiwan and Cambodia (20 per cent each) are India’s biggest competitors in attracting Foreign Direct Investment. Besides, 15 per cent tax rate for new manufacturing units will act as a fillip for the growth of the manufacturing sector in India. The gap between tax paid by manufacturing and non-manufacturing companies had been widening till 2018 which will narrow down a bit. In the first quarter of 2019-20, the manufacturing sector registered growth of a mere 1 per cent as compared to 12 per cent in the same quarter last year. The tax cut will increase firms’ profitability which should eventually raise salaries and wages. Tata Steel, JSW Steel, Eicher Motors, ITC and Britannia are seen to be the biggest winners from this decision.
Effect on fiscal deficit
Credit rating agencies stand divided in their perception towards tax cut. Credit Rating firm S&P Global termed it as a “credit negative” development due to concerns over rising fiscal deficit. But Moody credit rating agency called it “credit positive” as the tax cut is expected to raise investment levels, create new employment opportunities and increase national income. Undoubtedly, this move is bound to burn a hole in the government’s pocket. The tax cut is going to cost the government around 1.45 lakh crore rupees. With the GDP growth rate falling to a six-year low, reduction in corporate tax cut will make it quite difficult to achieve the fiscal deficit target of 3.3 per cent of the GDP as set by finance minister for the fiscal year 2020. Notably, Sitharaman’s predecessor, Arun Jaitley left a legacy of fiscal consolidation for posterity. He had inherited a deficit of 4.5 per cent in 2014 and left 3.39 per cent of the GDP in the fiscal year 2018-2019. However, a single digit deficit that is well within the limits should not alarm the government. For a developing economy, it is acceptable for the state to raise its expenditure while reducing its tax revenue to augment economic growth. Hence, the government should by no means reduce its spending, because for an economy to revive, both public and private sectors will have to work in tandem with each other by increasing their respective investment levels.
Demand side neglected
This move only addresses the investment side but neglects the demand side of economics which is necessary to solve the current crisis. Moreover, it is not necessary that the corporate sector will definitely pass on the benefit of the tax cut to consumers as history suggests. It is highly debatable whether the tax cut will benefit consumers anytime soon. This is a measure with long term ramifications. Hence, the time is ripe to appreciate honest tax payers with a gift of lowered personal income tax. The focus of the government should be on reviving rural demand. For this, employment opportunities in rural sector need to be raised. Most importantly, the government should not decrease its spending to compensate for the loss in revenue. This will counterbalance any increase in income due to tax cut. Rather, government spending has to necessarily increase as it has a quicker and a wider effect. To tackle the issue of fiscal deficit, the government cannot rely solely on the transfer of surplus funds from the RBI. It should look towards raising non tax revenue as well, while also engaging in privatisation of Public Sector Units with full transfer of control. If and only if it is complemented with demand side interventions, we can expect the seeds of the corporate tax cut to bear the desired fruits.
Picture Courtesy- The Financial Express