Post-Budget Blues: Why the Modi govt must lower taxes to revive growth

After an underwhelming 2019-20 Union Budget, it is time to face hard economic truths.

Begin with tax. Before the Budget, I had argued for a simplified flat tax — zero tax for annual incomes below Rs 10 lakh, 10% tax for incomes between Rs 10 lakh and Rs 20 lakh, 20% tax for incomes between Rs 20 lakh and Rs 30 lakh and 30% tax for incomes above Rs 30 lakh.

No exemptions, no cesses, no surcharges.

The amount of tax collected from those earning taxable incomes below Rs 10 lakh a year is relatively small. It involves laborious paperwork by assessees and draws valuable monitoring resources from the income tax department. A simple flat tax structure would increase compliance and revenue.

Unfortunately, the mindset of bureaucrats in the Ministry of Finance (MoF) remains stuck in the past. By imposing a surcharge on the very rich, the extra tax revenue is estimated to be less than Rs 10,000 crore per year — but it will cause the flight of several entrepreneurs to foreign tax jurisdictions. This could reduce overall tax collections, the exact opposite outcome of the ill-advised surcharge.

India's indirect taxes are now 9.5% of Gross Domestic Product, among the highest in Asia. The ratio is 4.7% in Indonesia, 5.6% in Vietnam and 5.8% in China.

What the Indian economy needs today is lower taxes to boost consumption and revive private investment. It is worth examining why the economy of the United States is booming despite an uncertain global geo-economic environment amidst a trade war with China. US President Donald Trump has many flaws — but he was right to slash corporation tax from 35% to 21% in his first year in office.

As a result, US companies are today flush with cash. Net profits have soared. That benefits everyone. Take one example: a firm with a taxable profit of $100 million now saves $14 million through the corporation tax cut.

Where does the extra money go? In three directions — one, to employees who get larger pay cheques which, in turn, boosts consumption. Two, towards investment by companies in new technology and machinery which generates demand in ancillary industries and boosts productivity. Three, to shareholders through higher dividends, once again putting money in the hands of consumers.

This win-win corporation tax cut has led to an historic low US jobless rate of 3.6%. The US economy added 2,24,000 jobs last month, handily beating economists' estimates. US GDP is growing at nearly 3% a year — nearly twice the rate of growth in other developed economies in Europe and Japan.

India's corporate tax rate is 25% for companies with a turnover of below Rs 400 crore. Add surcharges and dividend tax and the net rate though is nearly 30%. Companies with a turnover above Rs 400 crore continue to pay a basic tax rate of 30% which rises to over 35% with various surcharges and dividend tax. While the number of these large companies comprises just 0.7% of India's corporate universe, they account for over 90% of corporate tax revenue.

What all Indian firms need, apart from a lower tax rate (a promise given to them by former Finance Minister Arun Jaitley in the 2015-16 Union Budget but not yet fulfilled), is new bank lending. The 2019-20 Union Budget pledges to recapitalise banks with a corpus of Rs 70,000 crore. That is welcome. Toxic lending practices of banks, especially between 2005 and 2012, led to a build-up of huge non-performing assets (NPAs) which were kept hidden from bank balance sheets by lax Reserve Bank of India (RBI) oversight until 2015.

Under the Insolvency and Bankruptcy Code (IBC), bank NPAs have begun to fall but lenders remain stressed. Singed by heavy bad debts that have eroded banks' capacity to lend to companies, private investment has gone into deep freeze. This has led to a vicious cycle of rising unemployment, falling consumption and slowing economic growth.

The 2019-20 Union Budget does little to address these issues. For example, the allocation of Rs 100 lakh crore in infrastructure over the next five years remains on paper, the source of funds unclear. Early corporate earnings for the quarter ended June 30, 2019, have been disappointing. GDP growth in the quarter too is likely to remain subdued. The steep fall in passenger car sales is a warning sign.

The government's focus on welfare schemes is both necessary and welcome. But finding funds for these schemes will remain a challenge if the economy is not revived and corporate earnings remain soft. Instead of integrating India into the global economy, the government is seemingly bent on reversing the liberalisation paradigm set in place in the 1990s. In a move redolent of bureaucratic overreach, import duties on consumer goods such as air-conditioners and washing machines have mindlessly been doubled. They will probably be rolled back when the sheer illogic of this move — miniscule tax revenue but poor economic signalling — strikes the MoF.

By increasing tax on foreign portfolio investors (FPIs), which function as trusts, the government could end up discouraging foreign investment in India. To compound matters, the new tax on buyback of shares will hurt ordinary investors. Companies use buybacks to return cash to shareholders in lieu of dividends which are taxed. This avenue has been slammed shut.

The Union Budget has suggested the Securities and Exchange Board of India (SEBI) consider increasing the minimum public float of listed company shares from 25% to 35%. While this will impart greater liquidity and lead to better price discovery, several multinationals could delist from Indian stock exchanges.

The best regulatory regime is light-touch and rules-based — India's regulations are heavy-handed and tend to retrospectively overturn established rules.

The government's economic policies have focused (rightly) over the past few years on welfare schemes but ignored the demand-supply side of the economy. The best way to revive broad-based demand is by putting money into the hands of India's aspirational middle-class by moving towards a flat tax regime. And the best way to boost supply is to recapitalise banks, resume lending to corporates and revive the manufacturing industry.

Also read: 100% productive Lok Sabha: Our MPs, for a change, are working hard. Whom should we thank?