On September 20, Finance Minister Nirmala Sitharaman announced one of the largest corporate tax cuts in world history. For all companies that don’t avail exemptions or incentives, the new corporate tax rate was set at 22 per cent while for new manufacturing firms established after October 1 (and who start production before 2023), the corporate tax rate was set at 15 per cent. The prevailing corporate rate — 30 per cent. The relevant tax rate is with surcharges and cesses — this has been reduced from 35 per cent to 25 per cent (all firms) and from 35 per cent to 17 per cent (new manufacturing firms).
Analysts, commentators and economists have looked at these large, historical, tax cuts and debated whether they will have any impact on demand or GDP growth. A dominant belief is that this is a supply-side intervention and even if it were to have an effect on demand, it will be only after a considerable lag. Some are even opening that this is neither supply nor a demand-side intervention but instead a “gift” to the corporate sector; others believe that what is needed to revive demand and GDP growth are long-term structural reforms. According to them, only structural changes that kindle animal spirits, agriculture, quality of education, improved healthcare, etc. matter for growth acceleration. (Add a structural change in weather as well).
These Godot experts believe India’s time will come but only when Godot arrives — after much needed structural reforms. By definition, structural reforms mean policies that have not been in place, to date. Godot needs to answer as to how, and why, India managed to grow at 7+ per cent for more than a decade without structural change?
We believe that a large part of the recent Indian growth decline to 5 per cent is cyclical, caused by both global (trade wars) and domestic factors. A major contributor to India’s growth sluggishness (and decline) are distorted domestic policies, particularly corporate tax rates (highest in the world) and real policy rates (highest in the world).
We go into details below, but we do want to make an Econ 000 point — cutting the corporate tax rates is both a supply and a demand intervention. Even the supply effect will likely not take long to materialise. On the demand side, there is the wealth effect, due to higher asset prices. Assume for a moment that the stock market rise is at least 15 per cent for the fiscal year from the close of trade on September 19 (Sensex at 36,000 and Nifty at 10,700).
In one week, the stock market is up more than 8 per cent. We realise this maybe noise but the estimate of only an additional 7 per cent rise over the next six months is conservative. Each 1 per cent rise in market cap is approximately Rs 1.4 lc (lakh crore). A 15 per cent rise translates into an additional Rs 21 lc. Global estimates of wealth effect on consumption vary but a magnitude of .05 is reasonable, that is, the wealth effect can be expected to yield an additional [(.05*21) or 1.05 lc or] Rs 1,05,000 crore of consumption. [Note that we have completely ignored the wealth effect emanating from the likely stabilisation, and increase, in house prices]
An important additional demand effect is via additional investment. The sceptics (Godot fans?) will say that since there is excess capacity there will be no additional investment until demand magically reappears. Of course, this argument is close to tautological and as close to “Ganga gaye to Gangadas aur jamuna gaye to jamunadas”. With this view, there is no wealth effect and no investment effect and no growth effect — at whatever time we are, we are at a standstill. This logic defies logic. There is bound to be an additional effect on investment.
We will report on cross-country results at a later date, but we do expect a 2.5 percentage point rise in real investment over the next two years. This will take real investment close to 35.5 per cent of GDP or less than 1.5 percentage points away from the peak of 36.8 per cent reached in 2011Q3. Needless to say, this is additional demand, and additional GDP in the economy. And needless to add, but this investment increase is unlikely to occur if the RBI/MPC persist with the highest real rates in the world. Just like woman does not live on bread alone, investment is strongly affected by both tax rates and the cost of credit. The other policy shoe needs to fall for acche din to happen.
We can all speculate, and disagree, but there are some incontrovertible facts pertaining to FM Sitharaman’s announcement of September 20. Indian (and world) history was made on that date. A reduction of 10 ppt reduction in the corporate tax rate (CTR) is only exceeded by Germany’s 15.8 ppt reduction in 2001 and the US’s 14 ppt reduction in 2018 (from 35 to 21 per cent). However, for new firms, the reduction of the CTR to 17 per cent (CTR of 15 per cent and surcharges, etc, of 2.2 per cent), an 18 ppt reduction, is the largest on record since 2000 (OECD database). Very likely, such a big reduction is the biggest reduction in the world, ever.
Some Indian economists have asked for a reduction in the CTR for a long, long, time. I say so with some expertise because in none of the traditional economists’ pre-Budget consultative meetings over the last 22 years has the argument been made to cut the CTR. The discussion, argument, has always been to raise tax rates to keep the fiscal deficit down (this for more than 99 per cent of the participants). Earlier this year, only two economists argued for a cut in CTR — the same two also argued for a cut in the real policy rates. The rest said don’t tinker, worry about the fiscal deficit, etc. And yes, some experts said the real policy problem pertaining to Indian GDP growth was that the exchange rate was overvalued. Note that these expert views were made at the time of the lowest real (and nominal) GDP growth in decades.
Hence, when the announcement was made on September 20, there were some who thought this was fake news! That is how much history was in the making.
A real perspective on history is provided via the OECD corporate tax database for close to 60 countries (since 2000). The data has 1,155 observations on CTR and 1,057 country-year observations on change in CTR. For countries with a population above 5 million (682 observations), there are only 161 observations of any change in the tax rate. Of these, 126 show a decline; only 34 show a decline of more than 3 ppt and only 14 countries cut taxes in any year by more than 5 per cent (Germany did it twice 15.8 ppt in 2001 and 10.6 ppt in 2008). Other countries in the club of a 10 per cent cut in CTR are France (2018), Hungary (2017) and Paraguay and Turkey (both in 2006).
India now joins this club of bold tax policy-makers — just 2 per cent of the total changes made in the 21st century. As we said earlier, while data are not easily available, this is possibly in all history, since tax increases, like death, have been a certainty. And large tax cuts have been rarer than the sighting of the blue whale. That is how historic is the decision made in Modi 2.0 and FM NS 1.0. The nation owes a strong debt of gratitude to these two masters of India’s economic fate.
We want to end with a speculation. We believe that there is a strong possibility of a final corporate tax cut with the adoption of the direct tax code (DTC). The latter has to happen, and the most likely date is February 2020. The FM has left us with two corporate tax rates — 15 per cent (new manufacturing firms) and 22 per cent (all firms). Maybe the DTC compromise will be somewhere in-between — say 18 per cent for all firms?
This article was first published on September 28, 2019 in the print edition under the title ‘The making of history’. Bhalla is contributing editor, The Indian Express. Bhasin is a New Delhi-based policy researcher. Views are personal.