Corporation tax cut: Who bears the cost of revival plan?

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Updated: October 1, 2019 7:12:34 AM

There are already cries for abandoning the targets to revive growth from various quarters, and it will not be surprising if the FM takes the bite.

In fact, it does not make sense to reduce the MAT when the objective is to stop companies from availing concessions.

The reduction in the corporate tax rates announced in September was hailed by the industry, and brought much-needed cheer to the stock markets. The increase in Sensex by more than 3,000 points in two trading sessions cast aside the bear hug that had gripped the markets since the disappointing first quarter GDP estimate was released. Although the bond markets reacted with lower yield due to the fear of higher fiscal deficits, the overwhelming sentiment was buoyant. The government had been in denial mode all along about the economic slowdown, and the markets did not take the finance minister’s earlier Friday announcements of bank mergers seriously. However, the corporate tax rate reduction was taken as the government’s acknowledgement that the economy urgently needed stimulus to bring back animal spirits.

The best approach to tax reform is to broaden the base, and reduce the rate. Ideally, it would have been better to make a systematic reform by doing away with various tax concessions, and reduce the tax rate. Unfortunately, grandfathering the tax concessions will take time, and there will be pressures to continue them in one form or another. The approach adopted now is to make reduction conditional on not availing tax preferences. Perhaps, this is politically easier.

In implementing the rate reduction, the FM has fulfilled the promise, made five years ago by her predecessor, of bringing down the tax rate to 25%. Capital being highly mobile, ceteris paribus, the differences in tax rates can be an important determinant of investment flows. In most of the competing countries, the corporate tax rates were lower, and that is an important motivation for reducing it. In fact, having declared five years ago that the tax rates will be brought down to 25%, and having implemented this for companies with turnover up to Rs 400 crore, there were expectations of reduction in the budget presented in July. Perhaps, the lowest growth of GDP recorded in the first quarter over the last six years forced the decision to reduce the rate barely two and half months after presenting the annual budget, and with four months to go for the next one. To what extent this will reverse the trend, and cause a ‘V’ shaped revival, remains to be seen.
No serious tax economist advocates loading the tax policy with multiple objectives and proliferating tax concessions. The costs of tax concessions in terms of revenue foregone and distortions are high, and their efficacy in achieving the professed objectives is doubtful.

They mainly serve the political purpose of appeasing special interest groups. In fact, the revenue forgone statement in the budget records 28 items, under which the tax concessions from corporate tax are availed, and these include items like accelerated depreciation, export profits of units located in SEZs, transmission and distribution of power, development of infrastructure, mineral oil exploration, donations to charitable trusts and institutions, units established in north-eastern and Himalayan states, and processing and preservation of food items. Of these, deductions/concessions for export profits located in SEZs, accelerated depreciation infrastructure, and transmission and distribution of power account for 82.6% of the total. The share of accelerated depreciation alone is 48.6%.

With the reduction in the tax rate to 22% if tax concessions are not availed, lowering of the rate for new companies to 15%, and reducing the minimum alternative tax (MAT) from 18% to 15%, the new effective rate is estimated at 25.17%. The new companies may not come to the production scheme for the next five years. In fact, it does not make sense to reduce the MAT when the objective is to stop companies from availing concessions.

The market reaction, perhaps, is due to the mistaken belief that the gains from the tax cut are massive, from 35% to 25.17%. Prior to the tax cut, while the nominal tax rate, including the cess and surcharge, was 35%, the effective rate was much lower—just about 29.49% in 2017-18, the last year for which data are available. If the effective rate before the reduction is assumed to be the same as in 2017-18, and with the corporate tax collection estimated at Rs 766,000 crore, the revenue cost works out to Rs 1.12 lakh crore. The government has pegged the revenue cost of the new measure at Rs 1.45 lakh crore, which appears to be a bit exaggerated because the new companies will not be able to avail the lower rate until 2024, and many companies may not be eligible for lower tax rate if they avail tax concessions.

Even by taking the official estimate of the loss at Rs 1.45 lakh crore due to cut in tax rates, the loss to the Centre will be much less. Much of the loss is due to lower collection from the basic rates, and the cesses and surcharges have not been touched. Therefore, the states will have to bear 42% of the revenue cost, which is about Rs 60,000 crore. Besides, with lower tax rate, many public sector companies, particularly oil marketing companies, are likely to have much higher profits and will pay higher dividends, and going by the 2018-19 estimates of profits, the Centre should be able to receive at least Rs 15,000 crore. The overwhelming impact of the tax cut will be on the states.

Even though the presumed loss of revenue for the Centre is exaggerated, this is going to put additional pressure on the fiscal deficit situation. First, the revenue forecast, which assumes over 25% growth over the actuals reported by the Controller General of Accounts, is clearly an overestimate, and even after taking account of the higher RBI transfer, it would be difficult to achieve the target. Second, with the FM directing the spending departments to clear the pending bills and loosen their purses to revive demand, the expenditure is likely to increase. The FM has stated that, at present, she is not thinking about the fiscal deficit target, which is, in a way, preparing the ground for relaxing the target later. There are already cries for abandoning the targets to revive growth from various quarters, and it will not be surprising if the FM takes the bite. In the process, will we throw the baby and retain only the bath water?

Member, Fourteenth Finance Commission
Views are personal

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