As private investment remains muted, GDP growth slows and clamor for government intervention grows, India has announced big cuts in its corporate tax rates to bring them to par with Asian peers.
The tax cut is a positive long-term measure that incentivizes investment and improves the ability of companies to invest. However, at best it only partly compensates for regulatory uncertainties and higher costs of doing business in India that deter existing and prospective investors. It will also create macroeconomic complications.
On September 20, Finance Minister Nirmala Sitharaman brought down the top corporate tax rate from 30% to 22%. Manufacturing companies registering from October 1 will attract a lower effective tax rate of 17%.
This is aimed at luring away, among others, top electronics manufacturers such as Apple which may want to relocate because of the U.S.-China trade and tariff wars. These tax cuts were long overdue and are aimed at improving India's relative attractiveness as an investment destination compared with China, Indonesia and South Korea.
Investors, hoping that lower taxes will boost corporate profits, lapped up shares, lifting benchmark indexes Sensex and Nifty by over 5% -- the biggest single day gain in a decade.
The tax cut changes India's branding as a high-tax destination and will help revive private investment, say supporters. They argue that more investment will lead to more jobs and in turn increased disposable income. They add that beneficiary companies will use the tax windfalls to cut the prices of their goods and services, further boosting consumer demand.
The cut is a welcome measure. However, it does not fully compensate for deeper problems afflicting India Inc: poor basic infrastructure, difficulties in enforcing contracts, uncertainties related to investment protection and taxes as well as cumbersome land and labor regulations.
Sectoral mismanagement such as a price cap on pharmaceutical goods, export controls on minerals and excessive steel protectionism remains a deterrent. Regulatory rent-seeking continues to mar the prospects of automobiles and real estate, the two industries with most links with other industries and services. Until these issues are dealt with, long-term investors will continue to be wary of putting money in India.
Moreover, a corporate tax cut does not address the most pressing problem of a demand slump. According to the Reserve Bank of India, capacity utilization rose marginally from 75% in the third quarter of the last fiscal year to 76.1% in the fourth quarter, and is still low.
Businesses will not invest in new production facilities as long as existing ones are operating below capacity. Thus, demand must revive before companies start executing their expansion plans.
That is not all. Reducing the effective corporate tax to 17% for new manufacturing companies is a good move, but it will create scope for tax arbitrage and encourage existing companies to avoid taxes by shifting business to new factories.
Besides, it is difficult to understand why the lower tax rate is restricted to manufacturing companies -- why not extend it to services companies? The services sector now accounts for 54% of India's GDP. To push investment and economic growth, India needs all kinds of companies, not just manufacturing ones.
To make matters worse, the government estimates the corporate tax cut will cost it 1.45 trillion rupees ($21 billion), equivalent to 0.7% of GDP, and adversely affect the government's ability to support growth through spending. This comes as the country's GDP growth has already slipped to 5% in the April-June quarter -- the lowest in six years.
The government's auditor has already criticized it for underreporting its fiscal deficit. The latest tax cut proposal will worsen the situation.
What the government needs to do is twofold. First, it must fix the basic infrastructure -- especially the ports and logistics that adversely affect the time and cost of shipments and, in turn, India's export competitiveness. Pushing exports is more important now than ever as domestic consumption demand remains muted.
Then it needs to address concerns about consumer demand. It could lower the goods and sales tax and possibly personal income tax to improve buyers' purchasing power. That is not easy, given the shortfalls in tax collection, but it is what is really needed to address the current demand slump when exports remain sluggish with no near-term revival in sight.
Despite the stock market's exuberance, which has now predictably reversed, the corporate tax cut aimed at incentivizing private investment will not unleash animal spirits unless it is accompanied by measures to boost consumer demand.
Ritesh Kumar Singh is chief economist of Indonomics Consulting and a former assistant director of the Finance Commission of India.