India’s corporate tax cut, hailed as one of the biggest economic reforms in the country’s history, is seen as an ideal move to support the manufacturing sector and reverse economic slowdown.
In a surprise move on Friday, Finance Minister Nirmala Sitharaman announced the government will cut nominal corporate tax rate to 22% from 30%. As a result, the effective tax rate (including surcharges) has been brought down by nearly 10 percentage points to 25.17% from 34.94% across all sectors.
To help further incentivise the manufacturing sector, New Delhi also announced a tax rate of 15% for new manufacturing companies that are set up after October 1 and start production by 2023. Including surcharges, the effective tax rate for new manufacturing companies is 17.01%.
Friday’s announcement was almost unanimously praised by investors and businessmen alike. The move was compared to India’s economic reforms of 1991, which effectively opened the country to foreign investment, liberalised interest rates and introduced private capital into sectors monopolised by state-owned companies.
“This is the biggest response from the government since 1991,” Vallabh Bhanshali, chairman of Indian investment fund Enam Group, said. “This is a very big move and the market has recognised it.”
Sensex, India’s benchmark stock market index, soared 5.3% on Friday in the biggest daily gain in more than a decade as investors factored in an expected immediate uplift in corporate profitability. Foreign banks including Goldman Sachs, UBS and Morgan Stanley, as well as domestic houses Kotak and ICICI Securities, all lifted their Sensex targets.
Anand Mahindra, chairman of automotive-to-information-technology conglomerate Mahindra Group, believes the tax cut will help to attract more foreign investment.
“Nirmala Sitharaman fired a shot that will be heard around the world,” Mahindra said in a twitter post. “India has sent an invitation letter to global investors.”
In a note to clients, Nomura said the move has significant positive implications for corporate profitability, the broader Indian economy and market valuations.
Aside from the expected initial boost to activity and business confidence, the Japanese investment bank said India will experience a cyclical recovery followed by investment/exports-led growth in the medium term.
Under the new tax rate, India will be more competitive against its Asian peers in attracting foreign direct investment. India’s new effective tax rate of 25.2% is now in line with Asian economies such as China, South Korea, Indonesia and Malaysia.
In particular, the preferential rate for new manufacturing companies will put India in a better position to attract companies that suffer from the ongoing trade war between China and the US.
The new effective rate of 17.01% is about three percentage points lower than in Vietnam and Thailand, which are seen as possible relocation destinations for Chinese and American manufacturers.
“The scale and decisiveness of the move shows that India is serious about shoring up foreign investment and is finally ready to release the country’s animal spirit,” Natixis said in a client note.
Still, for the Indian economy to reach its full potential, though, more needs to be done to reform the country's land and labour reforms, it added.
For example, India requires that any firm employing more than 100 workers must seek and receive government permission before dismissing any worker. It also lacks an effective land leasing framework and a set of modernised property transaction records.
Some economists also point out that the massive corporate tax cut will put significant pressure on public finances and increase the government’s financial burden.
“[The tax cut] is credit negative for the sovereign as it aggravates mounting risks for the government in meeting its fiscal deficit target,” Moody’s said in a report on Monday.
Sitharaman estimates that the corporate tax cut will reduce government income by Rs1.5 trillion ($21 billion) for the current fiscal year, or about 20% of the government’s projected income of Rs7.7 trillion.
New Delhi will need to find ways to fill the income shortfall. It has, for a long time, relied on the divestment of stakes in government entities but there is little room to increase that revenue as it has already set multiple unrealistic targets over the years.
“While the reduction brings India’s corporate tax rate closer to peers throughout Asia and will support the business environment and competitiveness, a host of cyclical factors, including rural financial stress, weak corporate sentiment, and a slow flow of credit in the financial sector, remain headwinds to near-term growth,” Moody’s said.