Current tax cuts will expand the role of the private sector in our economy and create adequate opportunities in the non-farm employment sector
Argumentative Indians; it is true that most of us just love to have a debate on everything and anything. So much so that at times we’ve found ourselves getting embroiled in debates over facts, data and technical concepts. Something similar seems to be happening with the corporate tax cuts recently announced by Finance Minister Nirmala Sitharaman, as there seems to be some confusion on whether they are a supply side response or a demand side response. One wonders how anyone, who has studied economics, can view it as a supply side intervention? Economics 101; tax cuts put more money in the hands of people and, therefore, it is a demand side response. This is important because of the current slackness in demand and, therefore, a demand side intervention is critical towards addressing the current economic slowdown.
This makes tax cuts an important part of the counter-cyclical policies that are required in order to kickstart the Indian economy at the moment. At a 22 per cent tax rate, India now has an extremely competitive taxation policy compared to other countries in the region. The fact that there is a lower tax rate for fresh manufacturing companies at 15 per cent makes it all the better as we are witnessing a massive reorientation of global supply chains. These changes ensure that India is a tax-competitive country thereby sending a signal to the world that we mean business — which will give Prime Minister Narendra Modi’s favourite initiative ‘Make in India’ a big push over the next few months.
There are two aspects to the current tax cuts that are important to appreciate. First, before the tax rates were reduced, Indian firms had some of the lowest retained earnings among comparable economies. Consequently, a bulk of the fresh investments had to be financed by the banking system as our corporate debt markets aren’t deep enough. This meant that the capacity for private sector investment was constrained by the health of our banking system. This brings us back to why we didn’t witness private investments over the last couple of years even when we had robust demand — because of the Non-Performing Assets (NPA) crisis and the existing capacity from investments made between 2009-13.
The output gap has increased of late and one waits for our monetary policy to take note of it, but the lower tax rate for manufacturing companies will act as an attractive pull factor for firms leaving China. These investments will very likely reduce the output gap over subsequent quarters. Similarly, a lower level of corporate taxes will enable firms to have more retained earnings which can be utilised in the short run to deleverage or absorb any short-term shock over the past two quarters. Both will be critical towards strengthening our private sector, going forward.
A medium-term implication of this is an increase in equity financed projects, thereby expanding the role of the private sector in our economy. This will lead to creation of opportunities in the non-farm employment sector and will help shift our surplus labour from the primary to secondary sector. We’ve discussed the skewed dependence on agriculture for employment in nearly every Five-Year Plan or every Union Budget and this is for the first time we’re seeing a proactive policy response that’s capable of finally making it happen. The second aspect that needs to be discussed is the systematic overhaul of India’s taxation policy — and the thinking behind the reforms. For far too long, people thought that the relationship between tax revenue and tax rate is linear. That is, to get higher revenue increase taxes and for lower revenue decrease them. We were either oblivious or ignorant of the Laffer’s Curve as at one point we had taxes equivalent to more than 90 per cent of the income. Clearly, this thinking has changed as we’re now talking about lower tax rates with better tax compliance resulting in higher tax revenues. The fact that we chose 22 per cent as the Corporate Tax Rate should not come as a surprise or as a coincidence, as 22 per cent is the optimal tax rate based on the Laffer Curve analysis done in a previous article. We’re now looking at greater revenue mobilisation through promotion of economic growth and tax compliance. Therefore, the focus of our taxation policies has shifted towards acting as enablers of growth rather than focussing on revenue mobilisation. This is important as it signals a departure from our conventional way of economic and taxation policies.
On the revenue foregone, many have quoted the figure presented in the note as is but it is important to understand the non-linear relationship between tax rate and tax revenue. Post the reduction of rates, economic sentiment is upbeat and as economic activity picks up, we will see growth revive. Revival of growth combined with improved tax compliance will perhaps make up for a major part of the revenue forgone by the tax cuts. We’ve officially moved towards an optimal and modern taxation regime.
(The writer is a New Delhi-based policy researcher)
