By making certain assumptions about the exact values of CSR, corporate income tax, dividend distribution tax, and then the personal income tax paid by the owner, we estimate that before the Friday announcement, Rs 100 of profit before tax would have yielded Rs 43 to the owner. After Friday’s announcement, this goes up to about Rs 48 to the owner. The announcement has given a gain of about five percentage points. This is a useful progress.
When this shareholder goes on consume this Rs 48 by purchasing goods and services, the government takes a next bite out of this through goods and services tax (GST).
Illustration: Ajay Mohanty
Alongside, this is the question of risk, which comes in three parts. All investments face ordinary business risk, and this is perfectly fine. In addition, in the Indian environment, there are two additional components of risk. Firms face policy risk of events which can adversely impact their business model. As an example, in the Aadhaar case in the Supreme Court, firms who had built systems using Aadhaar were deprived of this infrastructure. Similarly, firms who had built systems using information from credit bureaus were recently deprived of this information access.
The third component of risk comes from the agencies. The Indian legal system contains numerous agencies, with high investigative powers, many threats of imprisonment, and weaknesses in the rule of law. Going to jail is a showstopper, but even if that is not in the picture, the expenditure on lawyers takes one more bite out of the cash flow. For a firm with a top line of Rs 100 crore and a net profit of about Rs 5 crore, payments to lawyers of about Rs 1 crore a year are a large expense. Only when a firm reaches Rs 1,000 crore of revenue does it feel safe about such legal expenses.
The private sector should be asked to bear normal business risk, and reap the fruits from innovating, taking business risk, and building a business. To the extent that the fruits of the labour are transferred to the government or lawyers, and to the extent that the business is vulnerable to policy risk and the agencies, this deters investment.
Policy makers can impact upon the reward-to-risk ratio by reducing tax rates, reducing policy risk, reducing the threat of the agencies, and reforming the legal system.
So far, we have focused on the desire of private persons to invest. Once the problems of the reward-to-risk ratio of private persons are addressed, private persons will nurture investment ideas. The next hurdle that they face is of a financial system that will fund investment projects. Both engines of the Indian financial system — banks and financial markets — are currently limping. Restoring the health of the financial system is required, in the high-growth strategy.
The high-growth strategy is thus a combination of changing the reward-to-risk ratio as seen by private persons, coupled with restoring the health of the financial system. The Friday’s action is one element of the high-growth strategy.
There is the question of fiscal risk associated with reduced tax rates. We have to look beyond the short-term impact of this one decision, at the big picture. In Indian macro policy, there are only two choices for an environment of fiscal stability. Fiscal stability can be obtained through high growth coupled with loose fiscal policy. Alternatively, it can be obtained through low growth coupled with tight fiscal policy.
We have to ask which of these two scenarios is more palatable. The traditional answer in India was to have loose fiscal policy coupled with high growth. To return to this configuration, we need the high growth strategy. The Friday action is one move towards the high growth strategy.
The short-term budgetary impact of cutting tax rates will be smaller than what meets the eye. The distortion associated with a tax goes up in proportion to the tax rate squared. When a tax rate comes down, the distortion imposed upon the economy goes down, which bolsters growth. When a tax rate comes down, the effort made by private persons to evade the tax goes down. When a tax rate comes down, the power of the tax administration goes down.
For all these reasons, simple proportionality is never found when tax rates change. When a tax rate is raised, the tax revenues obtained always disappoint. When a tax rate is reduced, the reduction in revenue is smaller than what meets the eye. This gives cause for optimism in anticipating a relatively modest impact upon fiscal soundness.
The writer is a professor at National Institute of Public Finance and Policy, New Delhi