Nirmala’s 15 Percent Masterstroke

Lost in the euphoria over Finance Minister Nirmala Sitharaman’s corporate tax cut from over 35 percent to 25.17 percent is the game-changing reduction of tax on new manufacturing companies to 17.16 percent, inclusive of cess and surcharge.

This lower tax applies to manufacturing firms set up after October 1, 2019 but before March 31, 2023. Entrepreneurs thus have a four-year window to start manufacturing companies to reap the benefit of tax rates equal to or better than rivals in China, Vietnam, Indonesia, Malaysia and Singapore.

Foreign firms like Apple and Microsoft can now set up new manufacturing units registered in India to save on tax and take advantage of India’s low labour costs as well as a relatively high level of software skills. A basic 15 percent corporate tax rate (excluding cesses and surcharges) is extremely competitive with China’s corporate tax rate of 25 percent and even with Western corporate tax regimes like the United States (21 percent) and Britain (19 percent).

Will the corporate tax cut spur demand? Companies that save up to 10 percent on tax will use the extra cash in three ways. One, to expand existing businesses. Two, to set up new manufacturing units, qualifying for a base tax rate of 15 percent (saving up to 20 percent tax compared to the rate they would have paid earlier). And three, increase dividends to shareholders.

All three will help boost supply as well as have a knock-on effect on re-igniting demand. Expanding old units and starting new manufacturing units will create jobs and a new set of wage-earners, spurring demand. More dividends in the hands of shareholders, many of them middle class, will give them more elbow room to spend.

Clearly though, the demand side needs more structural reforms to make a significant impact on the economy. Four stand out. First, easing monetary policy. India under previous Reserve Bank of India (RBI) governors suffered from high interest rates, squeezing demand. Inflation fell as demand plummeted, causing a deflationary spiral. Lower interest rates will moderate housing and car EMIs, encouraging consumers to return to the two industry sectors undergoing the most pain.

The second structural reform is adopting privatisation as an article of faith. The exchequer can garner over Rs. 2 lakh crore a year by a sustained divestment programme. A collateral benefit of privatisation is more efficiently run enterprises. Workers’ wages will rise, product quality improve and shareholders benefit. A virtuous cycle will be set into motion.

The third structural reform relates to land acquisition. The UPA-era land bill, modified by the NDA government, has been placed in cold storage due to its political sensitivity. This has caused damaging delays in infrastructure projects, ranging from new airports to metro networks. In its majority-heavy second term, the Modi government must bite the bullet and bring the land acquisition bill back to Parliament. The fourth structural reform involves labour. The government has moved forward gingerly to make retrenchment by stressed firms easier, balancing the financial compensation for workers with the rights of employers.

Beyond these reforms lie several other issues that need Financial Minister Sitharaman’s close attention. One, inflation targeting. India has for long set a 4 percent benchmark for inflation. This could be eased to 5-6 percent to allow demand to grow unrestricted. Two, the emphasis on the fiscal deficit is overdone. “Fiscal fundamentalism” has fatal flaws. In a growing economy with a low per-capita income base, the priorities are growth first, second and third. The fiscal prudence rules that apply to developed economies with per capita incomes 20 times India’s need not be followed blindly. While fiscal prudence is generally good, it must be flexible in extraordinary times. When an economy’s growth trendline dips from 8 percent to 5 percent, fiscal elasticity can ignite the demand that fiscal fundamentalism has dampened.

The finance minister’s immediate next step to spur demand is accepting the sensible and detailed recommendations of the Direct Tax Code (DT) panel. These have now been with Ms. Sitharaman for over two months. What is holding her back? It can’t be the fear of further tax revenue loss. A simplified DTC structure of personal income-tax rates at 5 percent, 15 percent and 25 percent would increase compliance. The respective slabs: no tax till Rs. 10 lakh. The next three slabs: Rs. 10-15 lakh, Rs. 15-25 lakh, and above Rs. 25 lakh which would attract the highest tax rate of 25 percent, eliminating all cesses, surcharges and exemptions.

This would align personal income-tax rates with the recent corporation tax cuts. It will put money in the hands of the salaried middle-class and self-employed. With lower tax rates and simpler return formalities, better compliance will neutralise any revenue loss.

Will the fiscal deficit rise to 4 percent of GDP following these multiple tax cuts? Unlikely. Much of the estimated Rs. 1.45 lakh crore deficit will be covered by privatisation, faster economic growth and greater compliance. Besides, a marginal rise in the fiscal deficit is a small price to pay for reviving economic growth.

As NITI Aayog CEO Rajeev Kumar said: “I don’t think tax cuts will leave a gaping hole in the fiscal numbers. There is buoyancy in growth. In the past, our tax buoyancy has been very good. Therefore, both direct and indirect tax collections will go up with growth. Asset sales will yield an additional Rs. 52,000 core over the budget estimate. Then you have got another Rs. 50,000 crore from the RBI which was not included in the Budget.”

Mrs. Sitaraman has the last word: “Tax cuts should be seen as a big supply side reform. We are giving 15 percent. No other country is offering such a low tax rate. Companies availing of this option (and not claiming any exemption or incentive) will not pay the minimum alternate tax. The best part is certainty – there is no sunset clause. Companies starting production on or before March 31, 2023, will pay just 15 percent tax. It will be difficult for any government to go back on this now.”―Business World