Courtesy the face-off between China and the United States, India has a once-in-a-generation opportunity to become the factory of the world for knowledge-intensive light industrial manufacturing in sectors such as electronics, pharmaceuticals and specialty chemicals. However, India’s competitiveness is hindered by an effective corporate tax rate that is 4%-points higher than America’s or China’s. This higher tax rate makes India uncompetitive in key export-oriented sectors and creates the need for expensive policy interventions like PLIs. For India to decisively capture the China+1 opportunity and transform the employment prospects of tens of millions of Indians, a corporate tax rate cut, rather than PLIs, is a necessary and a sufficient pre-condition for take-off.
Early signs of a recovery in corporate capex…
Corporate capital expenditure (or capex) in India has started to show some signs of recovering after nearly a decade of slowing down. This is evidenced by a slew of indicators, including but not limited to corporate credit offtake growth (see the dashed line in the chart below) – in FY22 this figure was in double digits after a gap of three years.
Delving deeper into corporate capex, we find that construction capex (which typically accounts for a quarter of the overall capex pie) is the area where the lack of dynamism is most worrisome. As shown by the exhibit below, construction capex has now been trending down over a decade now (both as a % of GDP and as a % of overall capex).
To be fair to the Government of India, it is trying through its own spending to juice up capex. In FY21, FY22, FY23, and FY24 (estimate), government capex has grown at 21%, 44%, 24%, and 37% respectively, significantly faster than both broader economic growth and faster than private sector capex (see here and here).
However, given the modest tax receipts of the Indian Exchequer (central government tax: GDP is a mere 12% compared to 25% for a developed country like, say, the UK), government capex is bound to be a small part of the overall capex pie in India (around 14%) and therefore cannot be expected to be the critical driver of capex growth in India. Corporate capex from the private sector has to be revved up to drive a sustainable economic recovery in India.
So, what can India do to get private sector capex revved up?
Economic theory suggests that the higher the corporate tax rate, the lower the incentive for a company to expedite capex. This theory is best understood by comparing the steel industry in United States and India.
As is well known, steel is a commodity and the price of steel is set by global supply-demand dynamics; no one company, regardless of how competitive it might be, is able to influence the global price of steel. The pre-tax profit margin of a well-managed integrated steel manufacturer tends to be around 18-20%. Furthermore, a $1bn capex for setting up a steel plant results in 1.3-1.4mn tons/annum of production capacity. Taking the current price/ton of steel ($750/ton), implies annual revenue generation of $1bn. Applying the pre-tax profit margin of 20% yields an annual PBT of $200 mn.
In America, this PBT becomes a PAT of $164 mn (applying an effective corporate tax rate of 18%). In India, on the other hand, this PBT becomes a PAT of $150 mn (applying an effective corporate tax rate of 22%). The steel plant owner therefore recovers his capex in America in 5 years versus 6 years in India (assuming a 10% growth rate and assuming that PBT margins remain stable at 20%).
In fact, there is a significant body of empirical work done by economists which shows that lower tax rates lead to accelerated corporate capex. For example:
The Government of India has shown that it understands both the above theory and its practical implications. In 2019, the Ministry of Finance, Government of India, slashed the corporate tax rate to 25% from 35%. However, even after this slashing, India’s corporate tax rate is higher than that for the world’s two largest economies – USA and China (see exhibit below).
Courtesy the face-off between China and the United States, India has a once-in-a-generation opportunity to become the factory of the world for knowledge intensive light industrial manufacturing in sectors such as electronics, pharmaceuticals and specialty chemicals. However, India’s competitiveness is hindered by an effective corporate tax rate that is 4% points higher than America’s or China’s. This higher tax rate makes India uncompetitive in key export-oriented sectors and creates the need for expensive policy interventions like PLIs. For India to decisively capture the China+1 opportunity and transform the employment prospects of tens of millions of Indians, a corporate tax rate cut, rather than PLIs, is a necessary and a sufficient pre-condition for take-off.
Nandita Rajhansa and Saurabh Mukherjea work for Marcellus Investment Managers (www.marcellus.in).
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