By accident, if not design, the government has effectively set itself a new lower tax trajectory for corporations.
It should take this as a given and work to ensure that this shift happens smoothly.
One of the short-term downsides of any dramatic change in the system of corporate incentives is that this leads to a pause rather than an acceleration of investment. This is because the systemic effects of one initiative can go far beyond what is intended by the government or tax authorities.
It is the same with the Narendra Modi government’s dramatic announcement last week to cut the effective corporate tax rate to 25 per cent for all domestic companies, and to 15 per cent for new manufacturing units. The second one is likely to become the default target rate for all new capacity additions.
The intention behind the move is obviously to promote ‘Make in India’ and the creation of new manufacturing capacity. That will, no doubt, happen. But it has also given cause for pause to those companies which were already about to start operations or midway through the investment process. Does the new tax break apply to them?
This is the clarification sought by the Indian Cellular and Electronics Association, an industry lobby that includes the likes of Apple, Foxconn and other manufacturers of mobile and related devices, and their suppliers. These investors are looking at India as the new destination after Chinese wages became uneconomical for labour-intensive operations. Since the new tax rates apply only to companies that set up units after 1 October 2019, those units that undershot the new starting date for tax incentives will clearly feel cheated.
At another level, The Economic Times reports that in many parts of India Inc, capex plans are on hold, since managements that anyway intended to invest in new capacity are weighing the advantages of putting up completely separate units in separate entities in order to be eligible for the lower rates. They will be wondering whether it is worth paying 25 per cent by expanding capacity in existing units when a new unit can lower their rates even more.
In short, the same 25 per cent tax rate that, at first glance, looked like a bonanza, is looking like a special favour to new units over old manufacturing units.
One can also surmise that, at some point, services companies will also want the same 15 per cent tax rate for themselves. What, they may ask, is the logic of favouring the manufacturing sector when services will anyway create most of the net new jobs?
So, what should the government do? Should it keep adjusting the deadline dates or continue extending small sops for additional sectors and units to prevent them from sitting on their hands, hoping for lower tax rates or a more tax-efficient dispensation?
The answer is no. The government has to assume that the final target level of corporate taxation is 15 per cent, even if this is to be achieved in stages. Just as two connected containers of water at different levels will finally come to the same level, whether the government likes it or not, the logic of having two different tax rates for the same kind of manufacturing investment will ultimately be counter-productive.
This means that future investments in manufacturing will mostly be in new companies or entities that are clearly entitled to the 15 per cent rate. If the government takes this as a given, it should use this short-term uncertainty as an opportunity rather than a complication that needs continuous tweaking.
The first lesson to learn is that it must complete its entire set of reforms and announcements in the shortest possible time, so that capex delays are shortened by replacing uncertainty about government intentions with certainty. Reform in instalments is a recipe for postponement of investment decisions, not a spur.
The second lesson is simpler: if all tax rates are going to head down, this is the time to eliminate – in one shot – the various tax concessions that allow companies to bring down their effective tax rates. It is also an opportunity to end the minimum alternate tax (MAT), which was instituted to eliminate the use of multiple tax sops in order to avoid taxes.
Just as those eligible for the new 25 per cent rate have to abjure any other tax concession, the government can make it clear that even existing manufacturing companies can be entitled to the same 15 per cent rate provided they give up all current tax breaks. This can apply to all new capacity installed henceforth. If needed, this tax cut can be done in two or three stages, with the final 15 per cent rate applicable from 2021-22 or 2022-23. This way at least some companies may avoid creating new capacity in new companies just for tax purposes.
The third lesson is about what not to do. Since companies will indeed move towards the new 15 per cent rate through various strategies, one has to expect existing units to slowly start hollowing out and moving manufacturing investments to new companies. The government should look the other way, if this happens.
The last thing you need to do is make life difficult for companies that are merely trying to move to the most advantageous tax rate, even if it means shifting capacity from one company to another.
It does not make sense to make criminals out of managements seeking the most tax-efficient status by artificially outlawing this shift. Creating new capacity, complete with new management, accounting and compliance structures, will anyway involve costs. So, the government should not put roadblocks to the shift, if this works for some companies.
By accident, if not design, the government has effectively set itself a new lower tax trajectory for corporations. It should take this as a given and work to ensure that this shift happens smoothly.