India’s sagging economic growth has finally forced the government to relax its strict fiscal deficit targets, but even that may not guarantee a recovery.
On Sept. 20, finance minister Nirmala Sitharaman announced a reduction in the country’s effective corporate tax rate from around 35% to 25%. For companies that do not avail of any other incentive or commission, the effective tax rate would be just 22%.
While India’s equity markets cheered the decision, the bond markets tanked on fears that the government may now have to borrow more to meet its expenses.
It is believed that the move, which involves forgoing Rs1.45 lakh crore ($20 billion) in annual revenue, will widen the government’s fiscal deficit—the difference between revenue and expenditure—from the current target of 3.3%, to 4% of GDP this financial year.
The rationale behind giving deficit targets a miss is that it will incentivise the private sector to invest more, as companies can now expect higher profits. This will eventually lead to, it is hoped, an economic revival.
Yet, there are serious caveats in this reasoning.
While rigid fiscal deficit targets can be constraining, as it forces the government to cap expenditure and squeeze out more tax from companies, an increase in fiscal deficit does not necessarily entail growth.
Taxes are not the real problem
Lower corporate taxes can stimulate growth, depending on what the companies do with the taxes they’ve saved.
Given the nature of the current slowdown, which is mainly due to weak consumer demand, there is no reason to imagine that private companies will invest more if their tax outgo decreases. If consumers are not spending in the first place due to high unemployment and diminishing wages, then additional investments become risky.
There may not be many avenues for companies to invest anyway. For instance, why would lower corporate tax rates encourage auto companies to ramp up production, given placid demand?
A more effective solution on the government’s part, then, would be to increase consumers’ disposable incomes by a direct injection of investment, instead of maximising private sector profits. Such a stimulus can also create new investment opportunities for the private sector by raising consumer demand.
The current corporate tax rate cuts are more likely to impact the distribution of income than growth or employment. Companies will now get a larger share of profits from existing investments, while the economy remains on the slow lane. There is a very real danger that this would exacerbate inequality.
All this, is deeply worrying.