The Corporate Tax Pre-Diwali Bonanza

Since the unveiling of her maiden budget on July 5, the finance minister has been besieged with one challenge after another in the economy, both external as well as domestic.

The first shock was the historically low rate of GDP growth of 5 percent in Q1FY20 and the consequent meltdown in the capital markets. Besides the overall challenge, the automobile and real estate sectors are clearly in stagnation mode.

While many measures have already been announced including monetary easing through reduced interest rates by Reserve Bank of India, so far there was no direct fiscal push being made.

Most commentators believed that government has very little fiscal space, given the shortfall in tax collections and increasing welfare expenditure in the various government schemes.

In this light, the pleasantly surprising pre-Diwali bonanza from the finance minister by way of a steep reduction in corporate tax rates is clearly a counter-cyclical fiscal stimulus measure, aimed at rejuvenating demand and consequently growth and investment impulses in the economy.

For existing companies, an option to pay income tax at 22 percent (25 percent inclusive of surcharges) has been announced in lieu of giving up exemptions and incentives.

When it comes to fresh investment in manufacturing by a new company, there is an option to pay income tax at the rate of a still-lower 15 percent (17 percent inclusive of surcharges) in lieu of not availing of exemptions and incentives. Companies in this category will enhance their retained earnings by a phenomenal 18 percent of the company’s profit before tax.

The earlier prevailing corporate rate in India, inclusive of Dividend Distribution Tax, had given India a dubious distinction of being at the top of the list of countries in terms of Marginal Effective Tax Rate. METR analysis accounts for direct and indirect tax, as well as tax related incentives, capital alliances, accelerated depreciation. METR is the annualised amount of tax paid as a share of pre-tax rate of return on capital.

An EY study shows that the United States’ pre-tax 2017 reform METR was at 34.6 percent which fell to 18.8 percent. Similarly, U.S. manufacturing investment in fixed assets was expected to rise annually by about $43 billion due to the tax cuts. Clearly, therefore, there seems to be a positive causal link between lower Marginal Effective Tax Rate and higher investments in the economy.

It is expected that the virtuous cycle of higher investments and growth followed by higher income and consumption levels will get triggered in the Indian economy due to these measures.

Based on the revenue foregone figure of Rs 1.45 lakh crore mentioned by the finance minister, it seems that she has factored in lower tax collections due to the reduced rates, and consequently, a higher fiscal deficit.

Additionally, as per the famous Lafarge theory, a 23-25 percent tax rate is the ideal inflection point at which investments peak in the economy. The finance minister, no doubt, will be hoping that the shortfall in collections will be offset by buoyancy in profits of the corporate sector.

All in all, this is perhaps one of the boldest corporate tax reforms undertaken in India’s recent history and demonstrates the government’s resolve in promoting growth and investment especially in manufacturing in India.

Hopefully, with the eventual rationalisation of GST rates into moderate rate brackets, India will truly emerge as one of the most attractive investment destinations from the point of view of post-tax return on capital.

Sudhir Kapadia is National Tax Leader, EY India.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.