Why India needs to rethink its corporate tax cut

There is nothing moral or immoral about taxation. It is the context that makes it favourable or oppressive. No two countries can ever have the same tax policy. It all depends on their comparative strengths and weaknesses and the social, economic and ideological aims that a government wants to pursue.

In September 2019, the Indian economy was in a place arguably worse than it was during the 1991 crisis. The gross domestic product for the September 2019 quarter had slipped to 4.5%, the lowest since 2013. Demand and investment were at a six-year low, manufacturing at a 15-month low, exports were decelerating, banks were saddled with non-performing assets, and core sector companies with untenable debt. After the collapse of the Infrastructure Leasing & Financial Services Limited, shadow banks too had begun to unravel. The worsening macroeconomic situation made the foreign portfolio investors flee the Indian capital markets.

In the midst of a collapsing economy, Prime Minister Narendra Modi was scheduled to hold two round tables with the captains of corporate America during his visit to the United States in late September 2019.

The government of India needed a fix – urgently.

On September 20, 2019, less than 40 hours before the Modi’s Houston event, the government announced a massive tax rate cut, lowering the base corporate tax rate to 22% from 30%, and to 15% from 25% for new manufacturing companies.

It was a bold move, perhaps the boldest by the Modi 2.0 regime. The “historic” rate cut meant a reduction of almost Rs 1.5 lakh crore in direct tax collections. But the decision was made without offering any hard evidence as to how it would jumpstart the economy. At best, it was a leap of faith.

The government argued that low tax rate would attract new investments, especially in manufacturing and this would spur the growth engine. A wider tax base would, in turn, make up for the fall in corporate tax collection. Eight months later, it’s time to reevaluate the tax rate cut.

Impact on FDI

The latest data released by the United Nations Conference on Trade and Development shows that India received a total of $49 billion of foreign direct investment, or FDI, in the Financial Year 2019. But more than half of it had already been invested before the government of India announced the corporate tax rate cut.

The data of Department for Promotion of Industry and Internal Trade shows that the total FDI inflows in the first two quarters of 2019, before the corporate tax rate cuts, was $26.1 billion. In the last two quarters, FDI equity inflows stood at $23 billion. Clearly, the corporate tax rate cut has not led to any out-of-turn spurt in FDI.

Another important feature of FDI in Financial Year 2019 was that the majority of it was invested into service industries and information technology. Out of the $26.1 billion FDI inflows during April-September 2019, 17.58 billion was invested in the services sector, according to the Economic Survey 2019-’20.

But the services sectors, including IT, have not received any tangible benefits from the steep cut in tax rate. With or without the tax cut, the sectors would have received these new foreign investments. On the other hand, the FDI in manufacturing sector has decelerated. In March, the Parliamentary Standing Committee on Commerce expressed concern over the constant decline of FDI in manufacturing. The tax cut failed to achieve its biggest stated goal, which was a boost of FDI in manufacturing.

Net loss

Perhaps the most worrying aspect is that the top 0.9% of India Inc has benefitted the most from the rate cut. The 2019-’20 Economic Survey stated that 99.1 % of companies in India had a gross turnover of below Rs 400 crore and were anyway taxed at the base rate of 25%. With surcharge and cess, their maximum marginal rate varied from 26% to 29.12%.

On the other hand, only 4,698 companies had gross turnover of over Rs 400 crore and their maximum marginal rate varied from 30.9% to 34.61%. Thus, the impact of corporate rate cut varied from a gain of 3.2%-13.5% of the existing tax liability for small and medium companies to about 18.5%-27.3% of the existing tax liability for large companies.

Companies which were already making reasonable profits, especially fast-moving consumer goods firms, have strengthened their balance sheets on the back of the tax savings. The annual reports of the top fast-moving consumer goods firms show they have not made any major greenfield investments. This is because in 2019-’20, the sector grew 2% slower than the previous financial year. If one takes a look across sectors, none of the top 10 corporate houses have started any major greenfield project. Few assets have changed hands as a result of the insolvency process, in which banks have taken a haircut, but that’s about it.

Lessons from the past

If not for the steep corporate tax rate cut, the government of India today would have had an extra Rs 1.45 lakh crore to provide relief to the poor. Alternatively, if the government had invested Rs 1.45 lakh crore in creating new infrastructure, it would have created tens of thousands of jobs, enhanced household earnings, increased productivity and upgraded country’s infrastructure.

Investments have slowed down not because of the corporate tax rates, but because of a lack of demand. It is only policy interventions and major reforms that will create demand. If the government had invested the foregone corporate tax of Rs 1.45 lakh crore in infrastructure, the resultant increase in factor payments would have boosted demand and this in turn would have expanded the economy.

It is instructive that in 1991, when the government of India opened up its economy and initiated major reforms, it increased the corporate tax rate to 45% from 40%. Yet, export growth increased by 20% in 1993-’94, inward remittances increased four-fold between 1991 and 1995, and FDI grew to $5 billion in 1994-’95 from a mere $100 million in 1990-’91.

India’s average economic growth, which was 4.4% before 1990, rose to 5.4% between 1990 and 2000 and to 8.8% between 2000 and 2010. All this while, India always remained a high-tax jurisdiction. Though the corporate tax rate was brought down to 35% in 1997-’98, a new dividend tax was introduced. According to the Organisation for Economic Co-operation and Development, out of the 94 tax jurisdictions studied in 2017, India had the highest statutory corporate income tax rate at 48.3%, including tax on distributed dividends.

The corporate tax thinking of the present government needs a vigorous debate and serious rethinking. Corporate tax account for about 55% of annual income tax collection. The relationship of corporate tax rate with investment, innovation and economic growth needs an empirical study. Only evidence-based tax policy and not impulsive, on-the-fly fiscal approach can boost the economy.

Ashish Khetan is a corporate lawyer and specialises in international economic law.