The corporate tax cut is one element of the high growth strategy


Business Standard, 23 September 2019


The most important problem in Indian macroeconomics is the decline in private investment. The decisions of private persons are shaped by the reward and risk from investing. When a business got Rs.100 of profit before tax, the cash that went to the shareholder, under certain assumptions, was Rs.43. With the reduced rate of corporate income tax announced on Friday, this goes up to about Rs.48. This move is in the right direction. More needs to be done, to change the risk/reward analysis of private persons, to get back to the high-growth arrangement. The greatest fiscal risk comes from low economic growth.

The part of aggregate demand which moves the most in Indian macroeconomics is corporate investment. There were two booms of recent decades, peaking in 1994-95 and 2007-08, and there are low values in the late 1990s and in recent years. To get back to growth, it is essential to get back to strong private investment.

How do private persons (domestic or foreign) make the decision to invest, either in a new firm or in the expansion of an existing firm? They look at the prospective reward-to-risk ratio, of the cash that is finally delivered back to the shareholder. For the moment, let us assume that a company gets to Rs.100 of profit before tax. How much consumption does this give the owners? When various parties take a bite out of this Rs.100, this reduces the benefits obtained by the owners, and thus reduces the reward-to-risk ratio.

The reward

By making certain assumptions about the exact values of CSR, corporate income tax, dividend distribution tax, and then the personal income tax paid by the owner, we estimate that before the Friday announcement, Rs.100 of profit before tax would have yielded Rs.43 to the owner. After Friday's announcement, this goes up to about Rs.48 to the owner. The announcement has given a gain of about five percentage points. While this is useful progress, India remains out of line in international comparisons.

When this shareholder goes on consume these 43 rupees by purchasing goods and services, the government takes a next bite out of this through the GST.

The risk

Alongside this is the question of risk, which comes in three parts:

Changing the reward-to-risk ratio

The private sector should be asked to bear normal business risk, and reap the fruits from innovating, from taking business risk, and building a business. To the extent that the fruits of the labour are transferred to the government or lawyers, and to the extent that the business is vulnerable to policy risk and the agencies, this deters investment.

Policy makers can impact upon the reward-to-risk ratio by reducing tax rates, reducing policy risk, reducing the threat of the agencies, and reforming the legal system.

The next step in the pipeline: The financial system

So far, we have focused on the desire of private persons to invest. Once the problems of the reward-to-risk ratio of private persons are addressed, private persons will nurture investment ideas. The next hurdle that they face is of a financial system that will fund investment projects.

Both engines of the Indian financial system -- banks and financial markets -- are currently limping. Restoring the health of the financial system is required, in the high-growth strategy.

The high-growth strategy is thus a combination of changing the reward-to-risk ratio as seen by private persons, coupled with restoring the health of the financial system. The Friday action is one element of the high-growth strategy.

Fiscal stability

There is the question of fiscal risk associated with reduced tax rates. We have to look beyond the short-term impact of this one decision, at the big picture.

In Indian macro policy, there are only two choices for an environment of fiscal stability. Fiscal stability can be obtained through high-growth and then even loose fiscal policy works out. Alternatively, it can be obtained through low-growth coupled with tight fiscal policy.

We have to ask which of these two scenarios is more palatable. The traditional answer in India was to make loose fiscal policy survivable through high-growth. To return to this configuration, we need the high-growth strategy. The Friday action is one move towards the high-growth strategy.

Projecting the impact on tax revenues

The short term budgetary impact of cutting tax rates will be smaller than what meets the eye. The distortion associated with a tax goes up in proportion to the tax rate squared. When a tax rate comes down:

For all these reasons, simple proportionality is never found when tax rates change. When a tax rate is raised, the tax revenues obtained always disappoint. When a tax rate is reduced, the reduction in revenue is smaller than what meets the eye. This gives cause for optimism in anticipating a relatively modest impact upon fiscal soundness.


Back up to Ajay Shah's 2019 media page
Back up to Ajay Shah's home page