Are low taxes the answer?

It was a blockbuster Friday on September 20 for the stock market when the finance minister gave it an early Diwali bonus. The Sensex saw its biggest gain in a decade, rising 1,921 points to close at 38,015. Investors and India Inc celebrated the reduction in effective corporate tax rate from 34.94% to 25.17%, which includes all cess and surcharges for domestic companies. That translates to 14-15% boost to post-tax corporate earnings.

“This is a once in 15-20 years kind of reform and will bring in a significant mindset change, right from the corporates to the investors,” says Samir Arora, founder, Helios Capital. The street was on steroids after the announcement, since this move will lead to higher retained earnings and, thus, a higher corpus for future investments or payouts to shareholders. But, it’s important to remember that the move comes at a time when the economy posted its lowest growth rate of 5% in six years in Q1FY20. The other side of the bargain: the government will have to forego revenue of Rs.1.45 trillion and the fiscal deficit may increase to 3.9% of GDP against the target of 3.3%. That means moving away from the path of fiscal ‘prudence’, a policy the current government has prided itself for upholding, time and again.

It may not be a bad bargain if the investments, especially new ones, come through. Now, new companies incorporated on or after October 1, 2019, making fresh investments in manufacturing, have the option of paying 15% without availing any other exemptions on the condition that production is commenced on or before March 31, 2023. The finance minister said the new rates will be comparable with the lowest tax rates in South Asian region and South East Asia. “The tax rate cut definitely ensures that India becomes more competitive in comparison with its regional peers,” says Nilesh Shah, managing director, Kotak Mahindra AMC. And this comes at a crucial time when Asian countries are trying to make the most of the standoff between US and China.

Undoubtedly, it is the government’s big move to fix the investment cycle. Arora feels that it is a smarter move rather than trying to fix consumption through rate cuts. “There is no saying what kind of demand growth will be triggered by GST rate cuts,” he says. But, while this is a huge sentiment booster for the markets and the economy, merely cutting tax rates may not necessarily send the companies rushing to expand capacity. “Investments are never a function of tax breaks, but a function of demand visibility. Once companies decide on expansion, tax breaks act as a catalyst, but it doesn’t drive the investment decision,” says Shankar Sharma, vice-chairman, First Global. 

Banks have been apprehensive to lend as they are still struggling with stressed loan books. Shah says the government has to ensure that there is adequate liquidity and the cost of capital remains low. “The transmission of rate cuts hasn’t been optimal so far. Now that the government has set the expectation quite high, it must ensure the reform momentum stays on course. It has to be a series of reforms that continues to improve the ease of doing business,” he says.   

In a single move, the government has managed to revive animal spirits, for now. It gives the market legs to remain buoyant in the short term, and for investors, that is a welcome change from the gloomy sentiment. But, whether companies will roll out the blueprint for expansion remains to be seen. For now, hope floats.