Tax reductions form a potent weapon which the Finance Ministry can use to address the current economic downtrend
Experience of growth suggests that it happens in cycles — at times growth is higher than the trend level, while at other instances, it’s lower. A cyclical slowdown is when growth is lower than the trend while a structural deceleration is when the trend growth is lower.
As discussed in numerous previous articles, our current downtrend is indeed cyclical and an indication of this is the first quarter (Q1) growth figure, which showed five per cent. Whether one believes the trend growth to be either 7.5, 7 or 6.5 per cent, it is highly unlikely that it reduces by 1.5-2.5 per cent within one year. Therefore, there is a cyclical component to the slowdown and that is perhaps starker than what was imagined a few quarters ago.
Macro 101: During a cyclical downturn, we need a counter cyclical policy response. This could come either from the monetary or fiscal policy. We will revisit the monetary policy later but for now, let’s focus on the fiscal policy which is under the purview of the Government. So far, we’ve seen a proactive Finance Ministry which has tried to address the problem through a series of measures. The Ministry has given adequate indications that it is less concerned about the fiscal deficit now. Further, the fact that the Finance Ministry will keep the expenditure constant while we will have a revenue shortfall is an indication that perhaps we are looking at an accommodative fiscal policy.
It is important to recognise that fiscal deficit is measured as a percentage of the Gross Domestic Product (GDP). Therefore, when growth is low, our GDP will increase at a slower, rate thereby lowering the denominator. Consequently, even if we were to cut our expenditure, the deficit is less likely to be at 3.3-3.5 per cent. Moreover, a reduction in expenditure will very likely have an adverse impact on the GDP. While we will reduce the numerator by cutting expenditure, we may further slow our growth which may imply, yet again, a higher deficit than before.
This means that the most prudent strategy would be to keep expenditure as before and continue with a revenue shortfall. This will have a positive impact on growth and even if the deficit was to be higher this fiscal, once growth revives, we will be back on our consolidation path within the next two years. It’s needless to say that fiscal deficits don’t really matter much themselves and at some point, we may have to revisit our macro-understanding but that’s a discussion for a later date.
The corporate tax cuts are again an important intervention that will play a key structural role in the medium term. These effectively forego revenue, thereby acting as a stimulus measure in the short term. All of this shows that we’ve got a Government that’s got its policy prescription right in terms of addressing the ongoing slowdown. It may take time for these measures to have a full impact and very likely we will witness this towards the first quarter of the next financial year but overall, we’re looking at the start of economic recovery.
There is another potent weapon with the Finance Ministry in the form of personal income tax cuts which can play an important role in addressing the current economic downtrend. But there are many other reasons for a personal tax cut at this juncture rather than just the slowdown. The biggest one is the likelihood of implementation of the Direct Tax Code (DTC) soon. Therefore, to reduce tax uncertainty, it makes a lot of sense to gradually converge to the tax structure that has been proposed under the DTC.
Moreover, since 2014, revenue from personal income taxes has grown at an annual average of 12.36 per cent (post 2016 it has grown at 15.40 per cent). There is no doubt that tax compliance has gone up and this improvement in tax compliance has come without a substantial reduction in tax rates. In fact, marginal tax rates have gone up. The fact that we have imposed a higher surcharge on the rich and super-rich further illustrates the need to rationalise our tax structure to further drive up compliance.
Luckily, during the corporate tax cut, the Government acknowledged the fact that compliance is higher at lower rates and, therefore, it may witness greater revenue mobilisation over the next few years. The same argument needs to be applied in the case of personal income taxes. So far, we’ve improved compliance at some of the highest tax rates and one of the most complex tax structures. Here’s a counterfactual: Imagine the improved tax compliance in a lower tax rate regime with a simple taxation structure. Who knows, counterfactual may soon become a reality?
(The writer is a New Delhi-based policy researcher)