Corporation tax cut a big positive, but demand recovery may take time

The finance minister’s announcement on Friday brought cheer to stock market participants and gave a boost to the broader markets, which recorded their highest single-day gains in a decade. Undoubtedly, the measures are sentimentally and structurally positive. However, the question now is whether these steps will stimulate demand and investments. Perhaps yes, but not immediately.

First, since the new corporation tax rates are now competitive globally, the move will help encourage foreign investments over the medium term, especially from companies looking at an alternative to China, and thus boost domestic consumption, too.

According to Sunil Jain, head of research at Nirmal Bang, “The new corporation tax rates are expected to be a great foreign-investment stimulus. This should boost job opportunities and the overall consumption demand in the medium-to-long run.” Many South Asian economies, such as Malaysia, Indonesia, China, and others like South Korea, have corporation tax rates in the 24-25 per cent range.

Employment support led by new investments made by domestic manufacturers is also expected, as all corporate entities are eligible for lower taxes. “Lower tax rates for new manufacturers are expected to further encourage investments,” Jain adds. Yet, some factors such as a likely delay in the revival of private capex cycle (given the current under-utilisation of existing capacities), and the absence of a direct push to individual incomes, may restrict immediate benefits on the demand front.

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“At present, the overall capacity utilisation, seasonally adjusted for Q4FY19, stands at around 75 per cent. Today’s decision is structurally positive. However, given that the threshold for firms to make decisions on capacity additions stand at 80-85 per cent, a turnaround in the investment cycle will not be immediate,” says Arjun Nagarajan, economist at SBICAP Securities.

How corporates respond to Friday’s tax cuts will be key. For instance, what could help near-term demand is if firms pass on tax savings to consumers in the form of price cuts, such as Titan, which said it would save 4 per cent from the rate cut and pass on the benefit to customers. What could also be positive is firms returning part of their tax savings to shareholders in the form of higher dividend and/or buybacks. However, this, along with potential valuation improvement on the back of a likely earnings boost, appears to be largely factored in after Friday’s rally.

Finally, what action the RBI takes in its MPC meeting in the first week of October, is crucial, given the increased fiscal deficit burden due to lower the tax rates. Experts believe further policy easing by the RBI and transmission of earlier rate cuts will faster demand recovery.

On the flip side, yields on the 10-year government bonds rose 15 bps, indicating that corporates depending on debt may have to pay a bit more for loans. Other challenges include the ongoing trade war between the US and China, as well as higher crude oil prices following the attack on Saudi Aramco’s facilities. Higher oil prices could also shave off part of the gains from higher growth expectations due to reduced corporation tax rates. Some experts are not sure how the government will react (curtail expenditure in some areas, etc) to higher fiscal deficit.

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