Economic recovery will be slow in coming

The cut in the corporate tax rate is seen as the boldest of the barrage of measures unleashed by Finance Minister Nirmala Sitharaman. It has sent the stock market soaring. There are expectations that an internationally competitive corporate tax rate will boost investment in the economy, both foreign and domestic, and lead to a massive creation of jobs and incomes. Such expectations need to be tempered by a dash of realism.

Let’s take foreign direct investment (FDI) first. There is little to suggest that FDI has been held back by the higher tax rate that obtained thus far. Gross FDI flows into India rose from $28 billion in 2013 to $42 billion in 2018, according to UNCTAD’s World Investment Report, 2019, despite India’s tax rate being uncompetitive. 

More crucially, the bigger chunk of FDI flows in the world, 63 per cent of the total, tends to be in the form of mergers or acquisitions (brownfield investment) rather than greenfield investment. It’s greenfield investment, not the brownfield variety, that can provide a big impetus to jobs and incomes. In India, brownfield investment is even more dominant than in the world as a whole: In 2018, it constituted 78 per cent of total FDI. The idea that, following the tax cut, a wave of FDI will dramatically lift jobs and incomes is rather misplaced. 

The cut in the corporate tax rate will enhance domestic corporate savings and could lead on to higher investment. Analysts have pointed out that the accretion to domestic corporate saving will be less dramatic than the headline numbers suggest. In effective terms, the tax rate goes down by only four percentage points. 

Even on this account, any increase in investment will happen only over the long run. In the short run, Indian firms are unlikely to step up investment significantly for several reasons. One, private consumption is faltering. Two, banks will be wary of increasing exposure to corporate groups with whom they still have to resolve bad loans. Three, despite announcements of infusion of capital, many public sector banks lack capital to increase lending significantly. At least for a year or two, corporate investment will be clouded by uncertainty.

The one thing that is certain is that the fiscal deficit will end up higher than the target 3.3 per cent for 2019-20 — perhaps closer to 3.8 per cent after factoring in various other effects including the RBI’s transfer of surplus. The finance minister has dispelled any expectation that the estimated revenue loss would be offset by a cut in government spending. Analysts who were cheering the government for announcing sector-specific measures while refraining from providing any fiscal stimulus will be disappointed.  

The government clearly believes that the slowdown is serious enough to warrant a fiscal stimulus in addition to the ongoing monetary stimulus. The question is whether the cut in the corporate tax rate is the best way of providing a fiscal stimulus at this point. Why not through an increase in government capital expenditure? Perhaps this does not fit in with the government’s thinking, reflected in the last Economic Survey, that private investment alone can be the primary driver of growth. The government may also have felt that public capital expenditure would not crowd in private investment in a situation where corporations are constrained by high debt-to-equity ratios. 

An increase in the fiscal deficit limits the potential for rate cuts by the RBI in the months ahead. The government may well have reckoned that the cuts in the policy rate have gone far enough. The issue now is one of transmission of policy rates and the creditworthiness of firms. Any increase in government bond yields on account of a higher fiscal deficit could be contained through a modest sovereign bond issue. 

The sector-specific measures announced in instalments earlier are a mixed bag. Some of these (such as the mergers of public sector banks) are of little relevance to the present slowdown. Others (such as timely refunds of GST to MSMEs and expediting payments due to them from the government) will help if implemented rigorously. The measures to boost exports are among the most promising. The special fund for last-mile funding for certain categories of housing projects will not make much of a dent on the large number of unfinished housing projects. 

The critical issue is the disruption of credit hitherto provided by non-banking finance companies (NBFCs). The government has proposed that public sector banks (PSBs) co-originate loans with NBFCs. One is not sure how this will work on the ground. NBFCs can pass on potential clients to PSBs for a fee. This will ensure flow of credit to particular segments but it does little to improve the financial health of NBFCs. A better option is for PSBs and NBFCs to co-finance loans. This will ensure flow of credit while also improving the health of NBFCs. But PSBs have no incentive to opt for this course except in cases where they have exposures to NBFCs. 

Neither the tax cut nor the sector-specific measures will change the near-term growth outlook dramatically. Indian firms, especially small firms, are going through a process of considerable adjustment consequent to demonetisation and the introduction of GST. Bad loans in the banking system declined in 2018-19 but remain at a high level of over 9.3 per cent of advances. Global growth has decelerated. The Seventh Pay Commission booster to consumption tapered off in 2018-19. The substantive effect of the measures announced may well be that it improves business and market sentiment and sets the stage for strong growth further down the road.

The writer is a professor at IIM Ahmedabad. ttr@iima.ac.in