Tax cuts may bolster growth eventually but fiscal impact comes sooner: Fitch

Last Updated: Thu, Sep 26, 2019 15:30 hrs
Fitch Ratings (PTI photo)

Hong Kong: India's corporate tax cuts support efforts to stimulate investment and GDP growth in the medium term but will cause the fiscal deficit to widen in the near term, Fitch Ratings said on Thursday.

As such, slippage from previous government fiscal targets this financial year (2019-20) is now very likely.

The cuts, announced by Finance Minister Nirmala Sitharaman on September 20, will lower the base corporate tax rate to 22 per cent from 30 per cent for companies that do not seek exemptions, and reduce the rate for some new manufacturing companies to 15 per cent from 25 per cent.

Including surcharges and cesses (levies to raise funds for specific purposes), the effective corporate tax rate will drop by nearly 10 percentage points to 25.2 per cent.

The announcement follows other measures of the government to prop up slowing GDP growth adopted since May's general election. These include efforts to reduce red tape and boost foreign direct investments, and plans to consolidate the state-owned banks.

"We would characterise these and the latest tax cuts as structural reforms to improve competitiveness and efficiency (for example, by reducing the use of tax exemptions) rather than as cyclical stimulus measures," said Fitch in a statement.

As such, they may succeed in stimulating investment, although a positive growth impact is only likely over the medium term. A positive impact on FDI will be more likely if the tax cuts were accompanied by further measures to improve India's business environment.

In particular, corporate tax rates are likely to be only one in a list of factors determining investment decisions along with the legal environment, labour market regulations, infrastructure development and enhancements to the overall business climate.

Meanwhile, faltering domestic demand, a weak global trade environment, asset-quality challenges at banks and funding pressure on non-banking financial institutions have all contributed to an economic slowdown. GDP growth slowed for a fifth consecutive quarter in April to June quarter to 5 per cent, down from 8.1 per cent year-on-year.

The contribution of private consumption fell to 1.8 percentage points from an average of 4.6 percentage points in the preceding four quarters, while manufacturing grew by just 0.6 percentage points.

"Our FY19-20 forecast for India will be significantly lower than the 6.6 per cent in our June Global Economic Outlook, but the policy measures taken will likely support a gradual recovery in FY20-21 and FY21-22," said Fitch.

In contrast to the growth impact of tax cuts, the fiscal impact will be felt in this fiscal year. The government says the cuts will cost around 0.7 per cent of GDP in lower revenue -- about two-thirds to the central government and one-third for state governments.

Revenues this year are already behind target although the record annual transfer of 24.8 billion dollars from the Reserve Bank of India announced in August should largely fill this gap.

"Expenditure postponements are more difficult for the government given weak growth, and we expect the central government to miss its 3.3 per cent of GDP deficit target for FY19-20 by about 0.4 percentage points. We now expect a general government deficit of 7.5 per cent of GDP, well above the 'BBB' category median of 1.9 per cent."

Fitch said this represents a change in its view on the fiscal stance from the July budget and underscores opinion that the general government debt ceiling of 60 per cent of GDP is unlikely to be met by March 2025, as stipulated by the Fiscal Responsibility and Budget Management Act, as this would require significant deficit reduction.

"The interplay of growth and fiscal policy is an important element of our Indian sovereign rating assessment. Higher sustained investment and growth rates without the creation of macroeconomic imbalances could be positive for India's credit profile while a rise in the government debt burden could be negative," said Fitch.