Corporate Tax Cut: A move towards Demand Push or just another move focused on Supply-side?

There is a huge hue and cry about the Indian economy being in doldrums. It started with the Automobile industry facing slow liquidation due to reduced sales figures, moving to the real estate sector, then to consumer durables market and percolating down to hitting the businesses of organizations operating in the FMCG sector as well. The reality surfaced with GDP growth figures announced in April’19 which stood at a mere 5%.

In order to revive the economy and boost the growth Finance Minister, Nirmala Sitharaman on 20 September 2019 announced a corporate tax cut. Earlier, corporates had to pay 30% which has now come down to 22%. Including surcharge and cess, the effective tax rate for existing companies would now come down to 25.17% from 35%. The move came amidst the on-going economic slowdown as the FM said reduced corporate tax regime would lead to increased investment and the benefit of tax cut would be accrued to customers by way of reduced prices. Chart (1) below depicts how this move will help big companies in saving more for themselves this year.

Appreciating the move, where the animal spirits, as the BSE Sensex notched up its biggest single-day gain in a decade, as sentiment boost and potential impact on investments overshadowed fiscal concerns. Companies, however, will be eligible for this tax cut only if they forego incentives and exemptions in force. While for those who chose to continue with the status-quo, the minimum alternative tax (MAT) was cut to 15% from 18.5%.

This move by Finance Minister got a huge applause from political leaders to industry experts. Before this move, India was one of the high tax levying countries, with this move, India has become attractive to foreign investors as well. This is primarily because now companies will have higher after-tax money at their disposal. This makes investment attractive because companies have a higher share of their profits with themselves and don’t have to pay it to the government. Chart (2) below shows how this move makes investing in India more attractive now.

While the move has been appreciated on the above-mentioned grounds, it becomes imperative to see what is the cost been borne by the government and if it if even going to fulfill the stated objective of bringing the economy out of turmoil. 

How bleak is the current economic scenario?

GDP figures show that the GDP growth has been very slow in the quarter ending March 2019 as it closed at 5%, the lowest in last 6 years, according to official data.

Not only this, but the investments have also slowed down and also the new investment projects have been seeing a drop as shown in Chart (3) below.

 Various sectors are facing negative growth and the sectors which are worst-hit can be seen in Chart (4) given below. All the figures depict how the economy has been struggling. Amidst all this, even the FMCG sector is not left behind, as the consumers have now started using the goods in lesser quantities as stated by prominent figures in the sector. When the economy is facing problems, generally the purchasing power of people goes down ultimately leaving them with lower money at their disposal for consumption. Due to this, consumers start rationing and save for the future.

These are all demand-driven factors due to which lesser consumption by consumers is leading to reduced spending and ultimately reduced liquidity in the market. Furthermore, the reasons for such a slowdown can be found in Figure (1) below. The chart shows how the RBI rate cuts are not helping, the slowdown in the automobile sector, perception of consumers around spending and GDP figures. This moreover covers the picture behind the slow-down.

Chart 3: Investment Growth in India

Chart 4: Worst-hit Sectors in Manufacturing

Figure 1: What explains the slump in the economy?

Is Corporate Tax Cut really the solution?

Corporate tax cut is moreover focused on solving the problems related to the supply side. The basic premise is that with reduced taxes, the costs of the organizations will go down and this benefit will be transferred by organizations to the end customers.

However, in reality, this might not be true. In such a scenario, organizations may decide to increase their capacity with the Capex expenditure and produce more while not reducing the prices. Also, they may decide to increase shareholder value by transferring the benefits to the shareholders by way of dividends. So, this again leaves the problem unsolved. This doesn’t solve the demand-side problem which arises from consumer perception of their incomes. Indian Consumers are not very positive about their incomes in the future and this means that they will not start spending unless they feel that they will have enough income in the future to meet their future needs. When this happens, they will try to save their present incomes for future in order to meet their demands when they don’t have enough income.

Where are these apprehensions originating from?            

The primary reason for this is the slowing down GDP figures and grim unemployment status. The situation of unemployment has been very bad with the unemployment figures reaching 45-year low in 2018. Rural, as well as Urban unemployment, has risen, Chart (5) below shows the current state of unemployment in the country.

The high levels of unemployment are one of the contributing factors leading to reduced purchasing power of the consumers and reduced spending by them.

Apart from this, if we look at the rural markets, the situation is further bad due to the high level of inequality persisting in the market. This inequality stems from the distribution of resources. In India, distribution of resources is so inefficient, that as of November 2016, the top 1% richest people owned 58.4% of wealth and top 10% owned 80.4% wealth. This means the bottom 90% of people have only 19.6% wealth with, where again bottom 50% only have 1.8% wealth with them. This shows the economic problem of the rich getting richer and poor getting poorer. If this situation continues to prevail then only the people earning more than average will have the purchasing power allowing them to make the necessary purchases required for boosting the economy. However, this is not sustainable because the Indian population is majorly dominated by people who have low-income levels and thereby, this makes the whole model of distributing major wealth among the rich inefficient.

The Way Forward

As mentioned, the corporate tax cut doesn’t solve the problem because it doesn’t solve the problem of demand generation. In order for the government to actually provide stimulus to the economy, the focus has to be shifted towards a consumer-centric approach whereby the government should invest in projects which provide a boost to employment along with higher wages. The wage story of India also doesn’t reflect a very rosy picture. With this cut, it is expected that the investment will get a boost, but it will not happen easily. The transmission mechanism is to be understood in this case in order to find out how the investment will get a boost. However, if demand continues to remain low, companies will not be willing to invest because perception regarding liquidity will remain low. So, more structural measures are required focused around increasing disposable income which can boost demand.

Another way of doing this is by reducing indirect taxes. Indirect taxes form 60% of the tax revenue for the government. This means that end consumers bear this cost. If the focus is shifted towards this, it will again help in increasing disposable income of the consumers.

The focus needs to be shifted towards investment projects focused towards low-income groups which helps in reducing the inequality while creating employment and increasing income at the consumer level.