As the optimism around the tax cuts gives way to more reasonable analysis, it is time to evaluate the impact of the tax announcements on the fiscal deficit. Any tax cut is revenue foregone and that has a fiscal cost. How will the government make up for its revenue shortfall and is it really a serious issue.
A steep bill of Rs.145,000 crore
If the initial statement made by the finance minister is taken into account, the cost to the central government is likely to be Rs.145,000 crore per year due to the tax cuts. This is, of course, the foregone revenue assuming that all domestic companies convert to the 22% formula. We will come back to this assumption later but the immediate impact on the fiscal deficit will take it higher from 3.3% to 3.97%. That sense of fear was visible in the bond yields on Friday as yields spurted to the 6.81% mark. Whenever a sharp rise in fiscal deficit is expected, the bond yields go up sharply. That is because; bond markets expect a surge in government borrowings to increase yields and crowd out private borrowers. Prima facie, the spurt in fiscal deficit by nearly 70 bps is a cause for worry because it will be accompanied by a rise in the CAD too, leading to an impact on the rupee as well as the sovereign ratings. As a host of economists have pointed, this could be the challenge. S&P has even warned this could be credit-negative for the sovereign ratings of Indian economy.
There are mitigating factors
In reality the actual impact on fiscal deficit will not be as large as the centre has projected. Firstly, the shift to the new 22% rate of tax is not going to be total. There are a lot of companies that will migrate over time since they may be currently enjoying exemptions. Secondly the cut in tax rates will also help to bring more corporates under the tax filing bracket. This will expand the tax base and result in better penetration. This will partially compensate for the loss of revenues. Thirdly, the special 15% tax formula for new investments is also likely to trigger a capital investment cycle that could expand profits and lead to higher tax revenues. Finally, lower rates also results in better compliance.
Rather be counter-cyclical
In a way, what the government has done is to take a counter-cyclical approach to boosting growth. When growth is weak, as we saw in the 5% GDP in June quarter, a proper counter would be to boost growth. If that boost comes at the cost of a temporarily higher fiscal deficit, then it is worth the risk. It has been observed even in global case studies that boosting growth at the cost of higher fiscal deficit is productive in the long run. Cut in tax rates can be passed on in the form of lower prices and that can also trigger a consumption boom. Fiscal deficit may not really be the big worry; at least for now! ©