Tax reform in driblets keeps the party going

Finance minister Nirmala Sitharaman looked relaxed and happy while briefing the press in Panaji, Goa, on Friday about the proposed corporate tax reductions. Her estimate of the loss from the revenue foregone is Rs 1.45 trillion — equal to half the estimated defence expenditure this year.

Normally, any FM under fiscal pressure would have mourned this loss of revenue. So why was the FM so happy?

And why a rethink on tax rates so early — just over two months after the Budget in July this year?

Readers will recall the short history of corporate tax reductions under Modi 1.0. Taking rates below 30 per cent was first mentioned in the FY 2015-16 Budget speech by the then FM, the late Arun Jaitley, who had said: “The basic rate of corporate tax is higher than the rate prevalent in other major Asian economies, making our industry uncompetitive. Moreover, the effective collection rate is just 23 per cent… because of tax exemptions”.

In FY 2016-17, the Budget speech tabled a detailed scheme for phasing out tax deductions -- a uniform depreciation rate of 40 per cent across old and new units; reducing the deduction to 100 per cent for scientific research, investments in priority sectors and agriculture; ending the deduction for social projects; phasing out the 150 per cent deduction for skilling projects, development of infrastructure facility, SEZs and production of mineral oil and natural gas.

Also, new domestic manufacturing companies were offered the option of a lower 25 per cent tax rate if they availed no exemptions or incentives. The basic tax rate for existing enterprises with turnover less than Rs 50 million was reduced marginally to 29 per cent. Profits of startups were made 100 per cent tax deductible in any three out of the first five years.

In FY 2017-18, the basic tax rate was reduced to 25 per cent for companies with a turnover less than Rs 500 million. This relief was extended in FY 2018-19 to companies with a turnover of up to Rs 2.5 billion, leaving the remaining one per cent of companies (around 7,290 in number) in the 30 per cent slab. In FY 2019-20, FM Nirmala Sitharaman carried forward the rationalisation by extending the 25 per cent tax rate to companies with a turnover of up to Rs 4 billion. This left 0.7 per cent of the number of companies in the 30 per cent tax slab.

What the most recent tax reductions do is that companies which opt for the “no-deductions route” can now switch to a lower base rate of 22 per cent. Compare this with what companies actually pay after availing of the deductions.  

This “effective tax rate” was on average 24.67 per cent in FY 2016-17. Hence, the new no-deduction rate of 22 per cent gives a relief of around 2.5 percentage points in the tax rate.  For new companies incorporated after October 1, the new nominal rate of 15 per cent is very attractive even against the effective average tax rate.

It remains unclear how the estimate of a loss of revenue of Rs 1.45 trillion was derived. The benefits for new companies will hardly have any impact this financial year. For existing companies, even if all of them switch to the new lower tax rate, the loss in revenue should be just around 10 per cent of the estimated revenue from corporate tax.  

Could the massive estimate of revenue loss be a covert attempt to paper over the data snafu while tabling the Budget in July this year? Readers will remember that the government chose to use the revised estimate for revenue receipts of last year rather than the authentic, provisional, actual estimate of the Controller-General of Accounts, which was around 11 per cent lower.

Inflating the base has inflated the budgeted receipts this year. Also factoring in the economic slowdown (a maximum of nine per cent GDP growth, against the budgeted 12 per cent), corporate tax is likely to be Rs 1.17 trillion lower than the Budget estimate even before the tax cuts of September 20. Hopefully, the government will share how the estimate was derived at some point. A plain reading throws up a revenue reduction of around Rs 650 billion less than one-half of the estimated loss.

The FM was right to be delighted by the market response, even if it was irrationally exuberant. The Sensex and the Nifty rose by 5.32 per cent. The former breached the psychologically sensitive 38,000 mark, and the latter the 11,200 mark. These were huge intra-day increases not seen in recent times, driven mostly by domestic institutional investors. Foreign institutional investors have preferred to keep their ammunition dry.

This exuberance runs contrary to the fundamentals. The Indian market is over-priced at the prevailing real economic growth rate of five per cent of GDP. The tax cuts can boost profitability, which in turn could improve the market valuation. But it is unclear by how much, by when and only subject to any devil in the details cropping up to spoil the party.

OECD forecasts a secular slowing down in economies everywhere. It marked India’s growth prospects down to 5.9 per cent this year, whilst also marking down world growth from 3.4 per cent to 3 per cent on the back of low growth expectations in the EU, Britain and the United States.

Tactically, the tax cut announcement was well timed to precede Prime Minister Narendra Modi’s “Howdy Modi” event in Houston, where he will meet US President Donald Trump, and subsequent meetings with the big boys of American business.

Also, with two Assembly elections coming up in Maharashtra and Haryana, Ms Sitharaman must have been feeling pressured to get her ducks in a row and improve public and investor sentiment.

Loan melas in 400 districts (nearly two-thirds of the total) in September and October are expected to add to the upbeat mood. All this has skidded into place just before the Assembly election dates were announced on Saturday.

The only silver lining around the corporate “tax reform” is that the loss of revenue is likely to be considerably less than the announced giveaway of Rs 1.45 trillion.

In the convoluted world of public finance, an avoided loss of budgeted revenue can also be a “gain” because it reduces the incremental stress on the fiscal deficit. That is something to cheer about.