In its boldest gambit yet to stir up the economy, the government on Friday issued an ordinance to reduce the corporate tax rate for domestic firms and new manufacturing units by 10 to 12 percentage points, effectively bringing India’s tax rates on par with its competing Asian peers.
Finance Minister Nirmala Sitharaman said that the effective tax rate for domestic corporates, inclusive of surcharges, will fall from 34.94% to 25.17% if they stop availing any other tax sops. For new manufacturing firms set up after October 1, 2019 and commencing operations by March 31, 2023, the effective tax rate will fall from 29.1% to 17%.
The story so far:
Finance Minister Nirmala Sitharaman on Friday, among other things, announced a significant cut in corporate tax rates, thus bringing down the effective tax rate (including various cesses and surcharges) on corporations from 35% to 25%. Also under the new corporate tax policy, new companies that set up manufacturing facilities in India starting in October and commence production before the end of March, 2023 will be taxed at an effective rate of 17%. Following the government’s decision, both the Nifty and the Sensex rose over 5%, which is their biggest one-day rise in a decade.
Why is the government cutting taxes?
The corporate tax cut is part of a series of steps taken by the government to tackle the slowdown in economic growth, which has dropped for five consecutive quarters to 5% in the June quarter. The most immediate reason behind the tax cut may be the displeasure that various corporate houses have shown against the government’s policies. Many investors, for instance, were spooked by the additional taxes on them that were announced by the government during the budget in July and began pulling money out of the country. The government hopes that the new, lower tax rates will attract more investments into the country and help revive the domestic manufacturing sector which has seen lackluster growth.
What impact will it have on the economy?
Tax cuts, by putting more money in the hands of the private sector, can offer people more incentive to produce and contribute to the economy. Thus the present tax cut can help the wider economy grow. The corporate tax rate, it is worth noting, is also a major determinant of how investors allocate capital across various economies. So there is constant pressure on governments across the world to offer the lowest tax rates in order to attract investors. The present cut in taxes can make India more competitive on the global stage by making Indian corporate tax rates comparable to that of rates in East Asia. The tax cut, however, is expected to cause a yearly revenue loss of ₹1.45 lakh crore to the government which is struggling to meet its fiscal deficit target. At the same time, if it manages to sufficiently revive the economy, the present tax cut can help boost tax collections and compensate for the loss of revenue.
What lies ahead?
Some see the present tax cut simply as a concession to corporate houses rather than as a structural reform that could boost the wider economy. They believe that the current economic slowdown is due to the problem of insufficient demand which cannot be addressed just through tax cuts and instead advocate greater government spending to boost the economy. Others, however, argue that lackluster demand faced by sectors like automobiles is merely a symptom of supply-side shocks such as the goods and services tax that have affected various businesses and caused job losses. If so, tax cuts and other supply-side reforms can indeed help the economy recover from its slump. However, the government will also need to simultaneously enact along with these tax cuts other structural reforms that reduce entry barriers in the economy and make the marketplace more competitive. The government could, for instance, extend the tax cuts to smaller businesses. The benefits of the present tax cut will also depend on whether the government sticks to its promises in the long run. Investor confidence in the past, it is worth noting, has been affected by retrospective changes to the law made by governments in the past.
