Explained: How the latest corporate tax rate cut impacts the economy

Udit Misra
According to the government’s calculations, the latest corporate tax cut would cost it Rs 1.5 lakh crore. (Express photo by Praveen Khanna)

Finance Minister Nirmala Sitharaman’s announcement to cut corporate tax rates on Friday morning was a welcome surprise for the Indian economy that has been struggling with growth deceleration.

According to reports, the government has cut the corporate tax rate for domestic companies to 22 per cent (inclusive of all cesses and surcharges) for domestic companies from the existing 30 per cent. What’s more, new domestic manufacturing companies, incorporated after October 1, will be asked to pay only as little as 15 per cent rate provided they start manufacturing by 2023 that is, a year before the next general elections.

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The stock exchanges zoomed within minutes of the news because for most established companies the tax cut would immediately lead to a pro-rata increase in profits. Given that corporate profitability has been hit in the recent quarters, the movement on the exchanges signals hope of revival in corporate fortunes.

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What does a corporate tax cut aim to achieve?

Essentially, a lower corporate tax is aimed at boosting investment by the private sector. The continuing deceleration of the Indian economy was being blamed both on depressed consumption by private inpiduals and decline in investment by private businesses. The two other factors contributing to growth government expenditure (where the fiscal deficit is under pressure) and exports (which have been stagnant), both have little space to boost growth.

The cut in corporate tax chooses to single out private investment. This is a long-term measure that would make it more attractive for existing and new businesses to invest and increase production, which, in turn, will create employment.

Does this mean that the GST Council may not cut GST rates?

It is quite likely that the GST Council may not effect any massive cut in GST rates because government finances both at Centre and state-level are stressed and there is little leeway to take a cut on overall revenues.

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Could the government have cut GST or income tax rate instead of corporate tax rate?

According to the government’s calculations, the latest corporate tax cut would cost it Rs 1.5 lakh crore. It is a valid question to ask if, given that the government was willing to take a hit of this magnitude, it could have spurred more economic activity by either cutting the indirect tax rate ( that is, the GST) or the direct personal income tax rate.

To be sure, cuts either in personal income tax or the GST would have yielded a higher immediate boost to economic activity as they would have reduced prices and immediately left consumers with more disposable income to spend more. Higher consumption spending would have enthused the business to get rid of inventories and possibly invest in new capacities.

So why not a cut on income tax or GST?

There are at least two possible reasons. One is the government’s diagnosis of what is wrong with the economy. As we have seen in the discussions within RBI, some believe it is the investment demand that is key to reviving India’s economic fortunes. If that is what the government believed, then a cut in corporate taxes gets preference.

The other reason is less theoretical and more practical. A cut in income tax only affects those who pay the income tax which is a very small number of the economy. So an income tax cut’s impact is limited by that.

On GST, a cut may have been more difficult to achieve because the decision is not contingent just on what the Centre wants states too have to play ball.

Lastly, it can be argued that while the immediate impact of a cut in corporate tax (on economic activity) is lower than the immediate impact of either an income tax cut or a GST cut, yet the long-term effect is decidedly more. Investment decisions are more long-term decisions and a cut in corporate tax would likely make it cheaper and more profitable for businesses to function in the Indian economy.