The Beginning of a Start?

Cutting corporate tax to accelerate growth could be the first step to structural change

Bravo, Nirmala Sitharaman. After becoming finance minister and presenting a second-rate Budget, you have seemed a timid tinkerer, making dozens of marginal changes to try and revive a sagging economy, in vain. Your image has changed completely with your bold, courageous slashing of corporate tax last week, from an effective 35% (with surcharges and cesses) to an effective 25.17%.

You have grasped that India’s structural failures are more important than the current cyclical downswing in GDP. Keynesians would have advocated a cut in indirect taxes and rise in government spending to give an anti-cyclical boost to a slowing economy. But that would have been a one-off effort, to be reversed soon. By contrast, the cut in corporate tax is a structural reform with long-term effects.

Dice Well Thrown

It will boost corporate incomes, which critics will castigate as pro-rich. It is not the best way of immediately boosting demand. But structurally, India will become more globally competitive, inducing more domestic and foreign investment and boosting exports. With a lag, this will hopefully boost GDP (and revenue) growth more permanently. It is a gamble, but a worthwhile one.

Your tax system remains flawed. You should simplify and make uniform many tax rates in the next Budget or two.

You have shown guts in sacrificing a whopping ₹1,45,000 crore (0.7% of GDP) of tax revenue to make India’s corporate tax rate competitive with that of Asian neighbours. Five years ago, former finance minister Arun Jaitley pledged to phase in a 25% corporate tax rate, which with surcharge and cesses meant an effective 28%. Since his announcement, our competitors have cut their rates further. You have cut corporate tax down to 22% for companies that do not avail of other tax breaks. Well done.

But you have also cut the rate on new corporations that start production by 2023 to just to 15%. That is a mistake. You need more uniformity and stability in tax rates. Why create yet another tax break when your aim is to eliminate existing ones? Focus on improving the climate for investment rather than tax breaks for a few.

Your July Budget levied a big surcharge on high incomes taking the top effective income-tax rate to 42%. You did not realise that this would apply to many foreign portfolio investors (FPIs) who are organised as trusts by law in their own countries. Hence, FPIs withdrew billions of dollars from Indian stock markets, causing a major slump. To assuage FPIs, you have exempted capital gains from the top surcharge. And, for uniformity, you have extended this tax break to Indian entities.

This is an improvement, but not good enough. You should simply have abolished the top rate of 42% that makes India totally uncompetitive. Your logic of making corporate tax competitive should apply to income tax too. Thousands of rich Indians have been migrating to Dubai and Singapore to reduce their tax liability, and your high rate will accelerate their exit, reducing, rather than gaining, revenue for you.

Every finance minister should know the hazards of creating a large gap between the corporate and top income tax rate. A large gap induces individuals to corporatise, or find other ways to channel individual income into their corporations, reducing tax revenue. Your sharp cut in corporate tax, welcome for other reasons, has increased an already large gap. That is why you should abolish new surcharges.

Vitaminising the Structure

You should also stop raising the income-tax exemption limit to woo middleclass voters. Relative to per-capita income, India has one of the highest tax exemption rates in the world.

Critics say you have abandoned fiscal prudence altogether through tax cuts for the rich. Yes, you have made a fiscal sacrifice, but not for populist spending. Structural change will ultimately induce faster growth, which is the best recipe for raising incomes for all.

Besides, the quality of fiscal deficits matters. Deficits for increasing productive investment are entirely defensible. That higher investment will, in due course, translate into higher growth that recoups the immediate revenue loss. Many countries with lower tax rates and collection rates than India have lower fiscal deficits too.

Your actual tax sacrifice could be much less than estimated. First, a big chunk of corporate tax is paid by public sector undertakings (PSUs) like Oil and Natural Gas Corporation (ONGC), Gail, Indian Oil Corporation (IOC), State Bank of India (SBI), NTPC, Bharat Petroleum Corporation (BPCL), HindustanPetroleum Corporation (HPCL) and Power Finance Corporation (PFC). They will now have higher profits that can be returned to you as dividends.

Second, many companies, especially multinational corporations (MNCs), pay a high proportion of profits as dividends. The new tax rate will boost dividends and, hence, boost your collections of dividend distribution tax (DDT) and income tax.

Third, by boosting stock market prices, you have boosted capital gains, and will collect proportionately higher capital gains tax.

Your gamble of cutting corporate tax to accelerate growth will succeed only as part of an overall strategy to make India more competitive. You must convince your Cabinet colleagues to make other inputs like land, labour, railway freight rates and electricity as cheap in India as in neighbouring Asian competitors. Cutting taxes rates alone will not suffice.

What do you think?