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Tax Cuts & Fiscal Deficit! Is It Worth The Risk?


Posted on 20-Sep-2019 Comments  0

Tax Cuts

A combination of corporate tax cuts and GST cuts give a big push

The FM’s press conference from Goa, ahead of the GST Council meet, was like a path-breaking budget in itself. Here is how tax cuts dominated on Friday

Corporate tax cuts

The Finance Minister offered a new tax formula under which Indian companies can pay just 22% tax on corporate profits. Of course, in exchange, they will have to forego all exemptions and rebates that are now available. The effective rate of tax, including surcharge and cess, will be 25.17%. Companies will have the option to opt for the 22% formula and they can either do it right away or at a future date. Such decision will be irreversible and going back to the old formula will not be possible after that. This lower corporate tax rate benefit will be available to all Indian companies irrespective of turnover. 

Boost to fresh investments

In addition to the normal tax cuts, the government also offered a lower bracket of 15% tax for new companies that set up manufacturing operations between October 2019 and March 2023. This move is expected to give a major boost to fresh investments by companies and also for the Make-in-India program. This formula will also exclude any kind of rebates or exemptions but offer a much lower effective tax rate. However, this benefit will be only for manufacturing companies and not for pure services.
MAT levels rationalized

To make the tax cuts more effective, the government also announced a major rationalization of MAT. Companies that opt for the 22% formula or the 15% formula (for new operations) will be exempt from MAT altogether. However, those companies that continue in the existing formula will also pay MAT at a lower rate of just 15% compared to the current rate of 18.5%. This is logical as once the rates are cut so low, MAT does not really have much of relevance. The lower MAT will also reduce the cost of existing tax paying corporates.

GST rates rationalized

On the day of the GST Council meet in Goa, it was non-GST aspects that really dominated the day. However, there was also some genuine effort on the GST front. For example, the Council cut rates of GST on semi-cut gems and also on contract labor for diamond industry. In addition, the GST Council also gave a boost to the hotels segment by cutting GST across tariff segments; exempting hotels with tariffs below Rs.1000 from GST. The GST on outdoor catering was also cut to just 5% to give a boost to the hospitality business. At the end of the day, one can always remonstrate that the GST Council did not cut the rates of tax on automobiles or on biscuits but there will always be future occasions. For the time being, this will go down as an action packed Friday.

Fiscal Deficit

Fiscal impact of tax cuts may be big; but it will be worth the risk

As the optimism around the tax cuts gives way to more reasonable analysis, it is time to evaluate the impact of the tax announcements on the fiscal deficit. Any tax cut is revenue foregone and that has a fiscal cost. How will the government make up for its revenue shortfall and is it really a serious issue.

A steep bill of Rs.145,000 crore 

If the initial statement made by the finance minister is taken into account, the cost to the central government is likely to be Rs.145,000 crore per year due to the tax cuts. This is, of course, the foregone revenue assuming that all domestic companies convert to the 22% formula. We will come back to this assumption later but the immediate impact on the fiscal deficit will take it higher from 3.3% to 3.97%. That sense of fear was visible in the bond yields on Friday as yields spurted to the 6.81% mark. Whenever a sharp rise in fiscal deficit is expected, the bond yields go up sharply. That is because; bond markets expect a surge in government borrowings to increase yields and crowd out private borrowers. Prima facie, the spurt in fiscal deficit by nearly 70 bps is a cause for worry because it will be accompanied by a rise in the CAD too, leading to an impact on the rupee as well as the sovereign ratings. As a host of economists have pointed, this could be the challenge. S&P has even warned this could be credit-negative for the sovereign ratings of Indian economy.

There are mitigating factors

In reality the actual impact on fiscal deficit will not be as large as the centre has projected. Firstly, the shift to the new 22% rate of tax is not going to be total. There are a lot of companies that will migrate over time since they may be currently enjoying exemptions. Secondly the cut in tax rates will also help to bring more corporates under the tax filing bracket. This will expand the tax base and result in better penetration. This will partially compensate for the loss of revenues. Thirdly, the special 15% tax formula for new investments is also likely to trigger a capital investment cycle that could expand profits and lead to higher tax revenues. Finally, lower rates also results in better compliance.

Rather be counter-cyclical

In a way, what the government has done is to take a counter-cyclical approach to boosting growth. When growth is weak, as we saw in the 5% GDP in June quarter, a proper counter would be to boost growth. If that boost comes at the cost of a temporarily higher fiscal deficit, then it is worth the risk. It has been observed even in global case studies that boosting growth at the cost of higher fiscal deficit is productive in the long run. Cut in tax rates can be passed on in the form of lower prices and that can also trigger a consumption boom. Fiscal deficit may not really be the big worry; at least for now!

Derivatives Tax

FPIs now have a tax advantage over domestic investors on F&O

As part of the tax rationalization for investors, the Finance Minister clarified on the buyback tax. The tax will not be applicable to companies that had announced buyback offers prior to July 05th. The FM also clarified on the much debated higher surcharge on FPIs and individuals. Finally, there is a lot more clarity on the subject of derivatives tax.

Derivatives tax for FPIs

For the foreign portfolio investors (FPIs) there is a lot more of clarity on the tax front. There were concerns that the higher surcharge imposed in the budget on super rich category, would also hit the FPIs structured as trusts or as AOPs. Previously, the government had clarified that the capital gains earned by all investors would be exempt from the higher surcharge announced in the Union Budget. But, areas of ambiguity still remained. There was lack of clarity on the surcharge applicable on F&O income and capital gains on bonds earned by the FPIs. Now, even that has been clarified by the FM. All capital gains earned by the FPIs from equities, bonds and futures & options will be exempt from the additional surcharge. That is because, in the case of FPIs, all gains on equity, debt and derivatives are treated as capital gains only. Since, under the traditional definition, the FPI would have already paid STT on these securities, these would be exempt from the additional surcharge. However, existing  rates of tax will continue.

Disadvantage Indian investors 

While exemption from higher surcharge is quite clear in case of FPIs, Indian investors may have a problem on hand. That is because, Indian investors of a reasonable size, are required to show income from trading in securities as Business Income and not as capital gains. It will be capital gains for a small investor or trader but then that person will not be paying super rich taxes. In the case of the super rich investors they will still have to pay additional surcharge since they show these gains as business income. While, there is a choice for local investors in case of equity gains, in the case of futures and options, they have to mandatorily show it as business income only. That would mean; gains on F&O will attract higher surcharge as will gains on bonds as there is no STT paid on these instruments.

Need for level playing field

It is here that the government must intervene and provide a level playing field for domestic investors. In the last few years, billions of dollars of Indian money has travelled abroad and this lack of level playing field would only accentuate the trend. The government has created unnecessary complications by an additional surcharge, which is unlikely to be productive in the final analysis. The easier solution would be to scrap the additional surcharge fully to give relief to all investors!

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