India’s tax cut euphoria wanes as economists count cost
India’s unexpected $20bn corporate tax cut, unveiled last week as the country battles a sharp economic slowdown, has triggered euphoria among business chiefs and equity investors.
Harsh Goenka, chairman of Mumbai-based industrial conglomerate RPG Enterprises, likened finance minister Nirmala Sitharaman to Lakshmi, the Hindu goddess of wealth, while investors pushed the BSE Sensex up 2.83 per cent on Monday following its 5.3 per cent surge on Friday.
“Just when the economy and street were losing hope, the finance minister, in a veritable Goddess Lakshmi avatar, has offered succour to millions of countrymen who were praying for a revival in the economy and a return to prosperity,” Mr Goenka told Indian reporters.
But economists are warning that prime minister Narendra Modi’s move will provide no immediate relief for India’s economic woes.
India’s protracted slowdown — during which GDP growth has fallen for five consecutive quarters to touch a six-year low of 5 per cent in the second quarter of 2019 — is widely seen as reflecting the lack of purchasing power among Indian households, which have drawn down savings and are tightening their belts.
Yet economists say New Delhi’s chosen fiscal stimulus method — which will cost the government about 0.7 per cent of GDP each year — will not swiftly strengthen consumer demand.
“This is classic trickle-down economics,” says Jahangir Aziz, head of emerging markets research at JPMorgan. “Nobody is doubting that the economy needed a boost, or policy support. But if you go down the list of choices they could have made, giving a corporate tax cut now wouldn’t have been in the top five.”
Cutting goods-and-services taxes, which would reduce prices, would be a more effective way to boost consumer demand, Mr Aziz said. Other economists say a cut in personal income tax would have a wider impact.
“There is a broad consensus that the real problem facing India is not that it is too expensive to do business but the fact that there is no demand,” said Mr Aziz. “If you want to boost consumption, you reduce the price of things people are buying.”
The corporate tax cuts are expected to yield dividends in the longer-term, helping woo job-generating foreign direct investment as US-China trade tensions rise. But any boost will come at a cost, putting pressure on India’s public finances in the absence of other big reforms — such as large-scale state disinvestment — to curb the fiscal deficitand check volatility.
“The biggest global supply chains are being reworked because of the US-China trade war and this is our once-in-a-century opportunity to juxtapose ourselves in this global supply chain,” said Ritika Mankar, senior economist at Ambit Capital. “The boost to the manufacturing sector is undeniable, but it means that India’s fiscal risks rise to the fore.”
In the tax cut package unveiled on Friday, India slashed its top effective corporate tax rate from nearly 35 per cent to just over 25 per cent, while slashing taxes on new manufacturing investment to 17 per cent — on a par with many south-east Asian economies.
New Delhi is betting that leaving more profits in corporate hands will dispel the gloom that has shrouded the business community, revive muted private investment, and draw renewed international attention to India as an investment destination.
“There is never a wrong time to do the right thing,” said Gurcharan Das, former chief executive of Procter & Gamble India and author of several books on India’s economy. “What they’ve done makes India competitive. If we want to get investment from those leaving China, we need tax rates that are competitive with those in Vietnam, Bangladesh, Indonesia and other countries to which they are moving.”
The tax cut would also allow Indian companies to pay down debt and increase dividends, leading to “higher purchasing power among the shareholders”, and undertake fresh capital investments, Mr Goenka told the FT.
“The animal spirits have been unleashed,” he said. “Hopefully that will lead to employment and higher disposable income, though there will be a lag.”
But in the short term, the tax cut is set to exacerbate India’s already worrying fiscal situation. New Delhi’s ambitious fiscal deficit target of 3.3 per cent of GDP was predicated on an 18 per cent increase in GST collection, which is so far up only about 6.5 per cent. This means fiscal slippage was already likely even before the tax cut announcement.
In weekend comments, Ms Sitharaman ruled out any immediate spending cuts but has not yet indicated how the deficittarget will be reached.
Analysts warn India’s central government deficit could rise to about 4 per cent of GDP. The level — coupled with high borrowing by Indian state governments and other public sector entities — is already weighing on the bond market.
“The risk is mainly for debt market investors, who now have to wait for more action to contain the risks created by the tax cuts,” said Ms Mankar.
Mr Aziz fears that the rising consolidated public sector deficit — already at about 9.5 per cent of GDP before the tax cuts — will drive up the cost of capital and threatens to crowd out the private investment New Delhi is so eager to encourage.
“With these kind of numbers, it’s very hard to see how investment can increase without corporates going abroad and borrowing, which means the current account deficit will go up,” said Mr Aziz. “But you don’t want to go out into this globally uncertain world to say ‘I need more funding’.”