A great deal will depend on how the MPC chooses to communicate its views on growth, and the role of monetary policy to undertake the ‘heavy-lifting’, post-fiscal shock
Last Friday’s corporate tax rate cut elicited a euphoric response from the stock market, compelling several analysts to revise their short-to-medium term growth projections upwards. This unanticipated, major fiscal boost is expected to stir the ‘animal spirits’, rekindle private investments, and stroke consumer sentiment through positive wealth effect. Is the growth optimism justified? History would tell us to be cautious! Recollect Mr Chidambaram’s dream budget of 1997, when he engineered a rather welcome rationalisation of personal income tax rates. What happened thereafter—the economy could not sustain the demand boost, and went into a recession couple of years down the line!
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That does not mean the 1997 rationalisation of income tax rate was wrong. Rather, it was successful in meeting its objectives of expanding the tax base and raising tax revenue in the medium-to-long run. In a similar vein, Friday’s corporate rate tax cut is most welcome; though its timing could be questionable.
While fiscal experts would like to debate if an economy with a per capita income below $2,000 can afford such a cut in corporate taxes, especially when rising income disparity is being projected as a long-term constraint to growth, India had very little choice in a world of “race to the bottom”. Matching competing counties in terms of tax incentives was imperative. Indeed, one could argue that it came a couple of years too late! It should have been done in 2016, when the domestic private sector was in great distress, and the government had windfall oil tax revenues to bridge the financing gap.
Fiscal imperatives binding constraint
But, the immediate question everyone wants to focus on is if this fiscal boost, estimated at 0.7% of GDP by the government, will revive growth? Before this announcement, there was near-consensus that there was little fiscal space for counter-cyclical fiscal measures. RBI Governor Das, too, had communicated this, in no uncertain terms, to the market a week before. How does this measure relate to the larger fiscal concern? In the macro perspective, this would increase corporate savings by 0.7% of GDP, with immediate effect. If the general government (Centre plus states) dissaving, i.e., fiscal expansion, also goes up by equal measure, the net impact on savings, and, therefore, investment, should be zero, assuming current account projections are retained. If household savings, and its financial component remain stagnant or decelerate further, then the growth outcome could turn more intriguing!
Since the government has not clarified its stand on the financing side, bond yields moved in the other direction, confusing even the rating agencies—Moody’s thought the changes are credit positive, contrary to Standard & Poor, which assessed them as credit negative! One thing, though, is clear—these tax cuts are structural, i.e., long-term commitments to firms, and, therefore, the tax shortfall will extend to multiple years. Corporate tax recovery would take time as it would depend on investment recovery, subject to evolving demand conditions. One should not forget the live lessons from faltering GST revenue collections in the face of a 14% tax revenue growth commitment given to the states, leaving very little space for counter-cyclical responses when growth falters! Which is why, now, many experts would urge more aggressive disinvestments to close as much of the financing gap as possible, subject to market conditions.
Divestment is not all panacea
How much could disinvestment help? Currently, we have many profit-making PSUs that can fetch good value in the market, which the government could tap. It needs to be flagged here that selling family silver would trigger a secular decline in non-tax revenues (dividend from PSUs). That is why, international agencies such as the IMF treat disinvestment proceeds as below-the-line (financing) item, unlike the government, which treats it as an above-the-line item.
Asset monetisation of land and building that currently yield zero return are ideal, but can materialise on a grand scale only when the private sector is ready to invest in greenfield projects!
Therefore, long-term debt sustainability issues cannot be wished away. The world over, investors now worry a lot about the global debt pile-up as inflation fails to respond. If growth fails to revive, the debt market could react adversely, forcing the government to raise effective tax rates, nullifying all that it is today hoping to achieve. There is very little choice left, except to cut current expenditure, especially, food, fertiliser, and petroleum subsidies, more aggressively than ever before!
Monetary policy communication could be critical
There is one significant difference between 2009-10, when the UPA-II government played with fiscal fire, and the current situation—lack of inflationary pressure. In hindsight, one could make a case for more aggressive easing than the 110 bps policy rate cut. Governor Das has consistently been communicating to the market that there could be more room for policy rate cut, in spite of geopolitical risks to oil prices. He has stuck to his stance even after the large fiscal shock, indicating the growth slowdown is cyclical, and output gap is large. While most analysts have retained their call for a 25-40 bps rate cut on October 4, a few are still making a case for a larger cut of 100 bps, or more.
The MPC has, so far, avoided committing publicly its stance on the real rate. It is difficult to visualise if it would opt for a monetary policy shock of 100 bps reduction, or more, in the policy rate given continued financial sector fragility. Government-pushed ‘loan melas’ could be another irritant. The MPC could possibly effect another rate cut, and then turn data-dependent. It would also prefer to wait and see if the latest RBI diktat on linking lending rates to an external benchmark is helping quicker transmission. The bond market is nervous as term-premiums are rising. The MPC needs to cool it down. A great deal will depend on how the MPC chooses to communicate its views on growth, and the role of monetary policy to undertake the ‘heavy-lifting’, post-fiscal shock.
Support with more structural reforms
Sunil Jain, in a Financial Express edit, made an apt comparison with the 1991 exchange rate devaluation—that it was required to be done, whatsoever might be the consequences. If the government’s objective is to restore a competitive edge for investment in India, for both domestic and foreign firms, this was a necessary structural reform, but not a sufficient one. It would need all-round support from other structural reforms in the factor and product markets. One hopes the government will not stop at this one, and carry on with narratives of other reform agendas into the following elections in Maharashtra and Haryana—two of our industrially advanced states!
The author is New Delhi based macroeconomist (Views are personal)