On September 20, the Indian government announced a reduction in the country’s base corporate tax rate from 30% to 22%, including a preferential rate of 15% for newly incorporated manufacturing companies.1 Unsurprisingly, Indian equity markets rose on the news.2
In our view, these reforms represent a significant change in policymakers’ economic approach: Previously, the government favored using monetary policy to boost growth, but this announcement signals that fiscal measures will now be a part of its policy mix.
The announcement marks a decisive shift in the government’s approach toward managing growth. We believe it’ll raise income and savings for businesses, accelerate investment—both domestic and foreign direct investment (FDI)—and increase the pace at which the informal economy is formalized. Coupled with other key initiatives (e.g., recycling state-owned assets and labor reforms), this could transform India’s investment environment.
Before the September 20 announcement, the government primarily relied on monetary policy and the Reserve Bank of India (RBI) to boost growth, while maintaining fiscal discipline. However, monetary policy hasn’t been as effective because the transmission of interest rates and credit has lagged policy decisions. This has contributed to the decelerating GDP growth over the past few quarters.
We believe slower growth might have tilted the balance, pointing the government in the direction of fiscal policy. According to our estimates, the tax cuts should translate to an economic stimulus of roughly US$20 billion, or about 0.7% of GDP for fiscal year 2020.3 Importantly, India’s new corporate tax rate should improve its competitiveness relative to most major Asian economies, and the preferential rate for new manufacturing firms will be one of the lowest in the region.4 We believe this policy move decisively raises India’s global competitiveness and will help efforts to attract manufacturing investment, which is consistent with the government’s preference of driving growth through investment rather than consumption.
Overall, we believe these reforms should incentivize greater domestic private capital investment, attract global manufacturing investment to India, create new jobs, and act as a catalyst to an investment-led economic rejuvenation.
Implications of tax reforms
We envisage the following possible outcomes from the reforms:
Boost earnings: Our estimates suggest the announced corporate tax cuts should translate into an 8% to 10% earnings improvement for the listed equity universe5 in India. We believe that businesses will use these tax savings in myriad ways, such as catalyzing consumer demand through price cuts and/or promotions, and investing in additional capacity to take advantage of the lower investment-linked tax rates.
Revival in the capital investment cycle: The reduced base income-tax rate of 15% for new manufacturing investment doesn’t have an expiry date in the near term as long as production starts by March 2023. Since this can translate into significant tax savings of seven percentage points lower than the new standard corporate rate, businesses could likely bring forward their capital investment decisions.
We also note that because of continuing U.S.- China trade tensions, many multinational corporations (MNCs) are looking to diversify their regional supply chains. MNCs could move part of their regional production to India to take advantage of the lower rates. We also believe the lower tax rate is an opening salvo in a package of government policies that may include further reforms on factors of production (e.g., land, labor) and the expansion of end markets through trade agreements (FTAs).
Higher fiscal deficit: As a result of the tax cuts, we estimate that the central government’s fiscal deficit in FY 2020 should increase from 3.3% of GDP to roughly 3.7%.6
Despite an increasing deficit, we expect only mild pressure on both interest rates and the rupee for a number of reasons:
- Global central banks easing should lead to benign liquidity conditions;
- Moderate domestic inflation gives the RBI room to cut interest rates further;
- Real rates for the rupee remain high;
- Global investors could be attracted to Indian equities as growth prospects revive;
- FDI in manufacturing could increase as a result of the tax cuts;
- Domestic tax buoyancy may improve with higher growth; and, last but not least,
- The government can pursue privatization of state-owned enterprises.
Overall, we believe there will be adequate capital to fund the deficit without putting much upward pressure on interest rates. If the government chooses to privatize state-owned assets, it would be, in our view, another big positive for the economy and markets.
"Overall, we believe there will be adequate capital to fund the deficit without putting much upward pressure on interest rates."
In our previous commentaries, we’ve always argued that the reelected administration has the unique opportunity to lift India's growth rate through what we call the “three R’s”—recycling, rebuilding, and reinvesting.7 With the current reforms, we see that the government is moving closer to this framework, which should boost India’s growth rate.
1 “India surprises with $20 billion tax cut stimulus; stocks soar,” Bloomberg, September 20, 2019. The preferential rate is for manufacturing firms incorporated after October 1, 2019, and starting production before March 31, 2023. 2 Bloomberg, as of September 20, 2019. 3 Manulife Investment Management estimates, September 25, 2019. 4 Bloomberg, KPMG, September 24, 2019. 5 Nifty 50 Index. 6 This estimate includes the assumption that some offsets will be available from the higher than budgeted dividend from the RBI. 7 “India’s incumbent government wins second election mandate,” Manulife Investment Management, May 24, 2019. The “Three R’s” are: 1) Recycle—growth could be lifted through selling state-owned enterprise (SOE) assets to fund government spending; 2) Rebuild—building domestic income and savings that could support investment; and 3) Reinvest—providing incentives to manufacturing firms to make investments to substitute imports and increase the global market share of exports.
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