20th September 2019 witnessed historic movement in the indices and broader markets. BankNifty was up almost 10% intraday and Nifty around 6% intraday. Reduction in corporate tax rates to 22%+surcharges has been a big surprise. The effective tax rate comes to 25.2%. The cut in tax rates directly affects the earnings of companies and no wonder, there was exuberance in the markets. What matters the most at this stage is analyzing the impact of this move and coming to a conclusion regarding investing your hard-earned money. Let us begin and try to analyze the objections that critics have against this move:
Structural vs. cyclical: This is one of the most debated topics in finance circles. A structural problem is one which is difficult to resolve. On the other hand, a cyclical problem is cured by the mere passage of time. In my opinion, the problem we have is a mix of both. This combination was topped up by the ill-effects of demonetization and GST. The move to reduce tax rates definitely does a bit to address the age-old structural problem of the Indian economy. (C+I+G+NX) represents the expenditure method of calculating GDP. ‘C’ represents private consumption, ‘G’ represents Government Spending, ‘I’ represents the Gross capital formed (Investments), ‘NX’ represents the net exports. Consumption has been the strength of our country and there is always a hue and cry about the lack of investment activity. The reduction in tax rates is likely to boost the investment activity by putting more money in the hands of corporates.
Will the private sector really invest? According to me, this is a time when corporates would be worried about getting the first-mover advantage. Everybody likes to expand their business and if the domestic players do not show the agility, foreign investors will grab the opportunity by way of FDI. The ease of doing business in India has been improving over the last many quarters. Reduction in tax rates was a long pending ask that companies had from the Government. The Government’s bold step is likely to boost the sentiment and help companies in allocating capital towards new capital expenditure.
Figure: Corporate tax rates in major economies; Source: News 18 and KPMG research
Where is the demand? This is yet another classic ‘chicken or egg’ situation of macroeconomics. Critics say this is not the time to put money in the hands of corporates. The real problem is that there is no money in the hands of the common man and hence there is no demand. Well, my counter-argument is why is there no money in the hands of the common man? (Because there are not enough jobs). Why are there not enough jobs? (Because there are not many entrepreneurs ready to commit capital). Why are entrepreneurs shying away from investments? (Because the rest of the world offers better investment opportunities). I believe, boosting the sentiment in the form of providing stimulus is a myopic step. The biggest curse is unemployment and the tax cut shows a silver lining in this aspect.
Fiscal stimulus -- > Boost the sentiment
Tax rate cut -- > Boost the confidence
What happens to the fiscal deficit? The incumbent Government’s commitment to fiscal prudence has been unprecedented. We may have done better on this front in the 1970s, but it is in no way an apple-to-apple comparison. What happens to the fiscal deficit is an important question. Here are my few cents on this:
Figure: Fiscal Deficit as % of GDP; Source: Trading Economics
Disinvestments: The incumbent Government has been focusing on increasing income via the disinvestment route. Their achievements are modest at best, as the disinvestment target was not met for the first 3 years of Modi 1.0. However, for FY 17-18 and FY 18-19, the disinvestment targets were exceeded. For the current year, the target is 1.05 trillion rupees. With the reduction in tax rates, it is likely that the private sector gets enticed to invest in these PSUs. There is a strong possibility that the disinvestment target for FY 20-21 will be ambitious and the Government will achieve it.
Figure: GoI disinvestment target; Source: www.dipam.gov.in
Wider tax-base: The anticipated increase in economic activity is likely to increase the before-tax profits and gradually help the Government fill the deficit of 1.45 trillion rupees as tax foregone.
Room for fiscal slippage?: Consider a worst-case scenario where the entire tax foregone of 1.45 trillion rupees moves to slippages. The current fiscal deficit is 5.39 trillion rupees. The percentage slippage in the worst-case scenario is 26% which translates into 4.4% fiscal deficit as a percentage of GDP. While the borrowing cost will increase significantly for the Government, one cannot forget the ongoing bull market in bonds. Close to 17 trillion USD worth bonds are yielding negative returns. The increase in borrowing costs will be at least partially offset by the global sentiment.
"Every coin has two sides and so do economic decisions. You cannot make everything right in one decision. It is a continuous process"
Conclusion: To be honest with you, I ain't an economist. However, being in the market for several years, this move of reduction in corporate taxes seems big from a corporate India perspective. I agree that reduction in rates is not the best weapon in the Government's arsenal at this stage. However, I find this as a more structural solution to a complex problem involving both structural and cyclical elements. Fiscal stimulus or reduction in GST is myopic when compared to a bold move of doing something for which India Inc has been craving for years.
The sporadic up-move we witnessed yesterday, may or may not survive in the immediate future, however, the medium to long-term looks brighter.
"By the time naysayers come to a conclusion, the concept of value stocks will again be history"