Obama’s protectionism may help India

US President Obama wants to end tax breaks that he thinks lead US companies to shift jobs to developing countries like India. Indian analysts fear this will hit foreign investment and jobs in India.

These fears are overblown. Indeed, the tax changes may unwittingly facilitate the takeover of US firms by Indian ones, showing once again that protectionism ultimately hits the protectionist.

The US imposes corporate tax on the global income of its companies, not just their US earnings. US companies have long protested that this made them uncompetitive in low-tax countries. To reduce this disadvantage, the US made profits earned abroad tax-free, until repatriated to the US. This tax break helped US companies establish large operations (and shift jobs) abroad. Obviously, the tax break was not the only consideration, but made outsourcing more attractive.

In the 1980s, countries like India and China were considered low-productivity areas that could compete only in labour-intensive goods like garments. But in the last decade China has become the world’s hub for most manufacturing, and India a hub for many global services. So, US companies have flooded into China and India.

They came initially for cheap labour. But soon they found that India had a greater comparative advantage in skilled than unskilled labour. Indian companies like Infosys, TCS and Wipro proved they were world class in computer software and business process outsourcing (BPO). Other companies showed that highly-skilled services could be outsourced to India too—credit ratings, radiological reports, legal services. And India’s scientific skills encouraged many multinationals to outsource R&D too. Others came to access India’s own market for goods.

Nasscom says that over 400 of the Fortune 500 companies now have operations in India. Over half our BPO exports come from foreign companies (Genepact being the biggest of all). Even in software, foreign companies account for one-third of Indian exports. And India has now become a low-cost global manufacturing hub for brain-intensive manufactures like autos. India’s skill advantages are seen to be so substantial that markets actually penalize US companies that do not outsource: their competitiveness is seen to be eroding.

Accenture, the big consulting company, now has more employees in India than in the US. IBM has around 70,000 employees in India, and one day it too will have more workers in India than the US. Other companies will follow suit. India is now an inescapable part of the US supply chain in a wide range of industries.

So, even if the new Obama legislation ends their overseas tax break, they will still find India competitive, even if somewhat less profitable. The Obama law will affect their operations in all foreign countries, so it provides no incentive to shift jobs from India to other Third World competitors. And shifting jobs back to the US will be uneconomic. In the current recession, companies cannot afford to raise their costs, and will shift jobs back to the US only if forced to (as is the case with companies being financially rescued by the government).

The new protectionist legislation has yet to be fully debated and finalized. But it seems right now that expenses on R&D abroad may continue to be tax-deductible. If so, the R&D operations of US companies in India can be arranged to maintain the old tax break, fully or partly. This will benefit not only medical companies but industrial ones using India as an R&D hub. It will also help companies like IBM, Oracle and Microsoft that do software R&D in India.

To the extent Obama reduces the profitability of US companies overseas, he improves the competitiveness of rival Indian companies. So, he will, unwittingly, give Infosys and Wipro an edge over IBM and Accenture.

We once feared that Infosys and Wipro would be taken over by US giants with deep pockets. But Indian companies have held their own. Indeed, studies suggest that the captive units of US companies in India have poorer prospects than Indian rivals.

This is reflected in price-earnings ratios, which reflect long-term prospects. Bloomberg estimates the ratio for the coming years is only 11.4 and 11.5 respectively for Accenture and IBM, but 17.2 and 22.0 for Infosys and Wipro. So, the market is implying that the Indian companies are inherently more competitive. Their higher ratios suggest that, in the long run, the Indian companies should find it easier to take over their US rivals than the other way round.

Any such event is surely a long time off. But by reducing the profitability of IBM and Accenture, Obama may have hastened the eventual takeover. Thus does protectionism boomerang.

What do you think?