Underestimates & overreactions: The math behind FM's corporation tax cuts

Why the impact of the corporation tax cut may not be as substantial on the fisc or on India Inc

The big question that has arisen after Finance Minister Nirmala Sitharaman’s corporation tax rate cut decision last Friday is what its actual impact would be on the government’s fiscal situation. On Friday, Sitharaman said the measures (see table) would result in forgone revenues worth Rs 1.45 trillion.

This was a huge amount — almost 19 per cent of the total corporation tax the government was to collect during the current year. This would have also meant a widening of the fiscal deficit by about 0.7 per cent of gross domestic product (GDP). In other words, the government’s fiscal deficit would have increased from the budgeted 3.3 per cent of GDP to 4 per cent.

But on Sunday, Sitharaman told media people that she was expecting improved compliance after the tax cut and that would help her stick to the fiscal deficit target. She also said she had no plans to cut government expenditure either.  

What has given Sitharaman the confidence to claim that there would be no fiscal slippage or expenditure squeeze?

If you dig a little deeper into the manner in which the finance minister has changed the corporation tax rates, you may get a sense of what lies behind her confidence. She is banking on many tax-paying companies giving up their tax exemptions and incentives and opting for the new lower tax rate of 25 per cent. Remember that the lower tax rate of 25 per cent can be enjoyed only by those who give up the existing tax exemptions and incentives. And once you give them up, there is no way you can return to the earlier regime of enjoying those exemptions!

How much did the government give up by way of revenues on account of these exemptions and incentives? In 2018-19, revenues worth Rs 1.08 trillion were forgone by the government owing to as many as 28 different types of tax exemptions and incentives. These are exemptions and incentives for exports, accelerated depreciation, setting up of units in special economic zones and investments in specific states. Over 80 per cent of the revenues forgone by the government are on account of export benefits and accelerated depreciation.
 

Hypothetically, therefore, if all companies opt for the 25 per cent tax rate and give up their exemptions, the government stands to save an amount equivalent to Rs 1.08 trillion. This is the actual amount of revenues forgone in 2018-19 on account of these exemptions; there is no estimate yet of how much revenue would be forgone on this account in the current year. It is possible that the entire tax amount forgone on such incentives will not be saved — because some companies may prefer to continue with these exemptions — but certainly, a large portion of the savings will not be required to be spent. So a part of the revenues forgone by Sitharaman’s decision to reduce the corporation tax rate would be made good.

Remember that the effective tax rate for Indian companies (the actual incidence of taxes on companies after taking into account the benefits from tax exemptions) was about 29 per cent in 2018-19, compared to the actual tax rate of 35 per cent. Thus in the aggregate, the net tax benefit for India Inc would be four percentage points (down from the effective rate of 29 per cent to the new rate of 25 per cent).

But the impact of the tax rate change, taken together with the loss of exemption benefits, would vary from company to company. Financial services companies like banks would hugely benefit because they do not enjoy any tax exemption benefits at present. But a large number of infrastructure, public sector and information technology companies enjoy the tax exemption benefits in a big way. If they too opt for the new tax rates, then the government will be able to forgo less revenue on tax exemptions.

If the stock markets have risen sharply, it is largely because of the preponderance of the financial sector companies in the benchmark indices of the Bombay Stock Exchange and the National Stock Exchange. This may also be why a CRISIL Research study of top 1,000 listed companies shows that their total tax gains on account of Sitharaman’s tax bonanza would be only about Rs 37,000 crore.

In the end, a bigger question arises. If the actual gain for India Inc is so little and the government’s revenue loss will be much less than the feared Rs 1.45 trillion, is the actual tax stimulus far less than earlier estimated and have the stock markets reacted prematurely?

To be sure, the government’s fiscal woes are not going to be over even if the impact of the corporation tax cuts on its fiscal deficit turns out to be lower than Rs 1.45 trillion. The gross tax collection shortfalls in the first four months of the current financial year (they are growing by just 6 per cent, compared to the budgeted goal of 18 per cent) will mean that the fiscal deficit target of 3.3 per cent of GDP would be difficult to achieve in any case.