India Tax Insights – ninth edition
Measuring the investment impact of government tax policy
President’s Fellow, School of Public Policy, University of Calgary and National Policy Advisor, EY Canada
Senior Tax Professional,
Government policies that matter significantly in emerging economies like India are those that spur capital investment. High investment levels lead to new businesses, growth in labor demand and rise in per capita gross domestic product and living standards. To improve the living standards of its citizens, the Indian government should, therefore, provide a favorable environment for investment. This could be achieved through various policy measures, including reducing the business tax burden on investments.
We consider the cost burden imposed by India’s system of direct and indirect taxes on investment at the national and sectoral levels. We do this by developing an economic model of the Indian tax system and using it to evaluate changes to the tax system affecting investment costs and incentives. We particularly focus on the upcoming goods and service tax (GST) reform and changes in corporate income tax policies.
Our tool for evaluating the impact of the Indian tax system on investment incentives is the marginal effective tax rate (METR), which measures the tax wedge imposed upon the profitability of investments. This tax wedge is the difference between the pre-tax rate of return earned by a marginal investment project and the post-tax rate of return earned by its investors. The size of the tax wedge (and METR) is affected by direct taxes, sales tax on capital purchases and other capital-related taxes such as stamp duties. The measurement also takes into account tax-related incentives such as initial allowances, accelerated depreciation and tax credits. High METRs reduce returns to investors, hurt India’s competitiveness and discourage investment. Variations in tax burdens across business activities distort the allocation of capital that would otherwise be put to its best economic use. The discussion on how GST and changes in corporate income taxes (CIT) affect METRs and investment incentives follows below.
A GST is a value-added indirect tax and is therefore, by design, a tax upon consumption. As a well-designed consumption tax on final goods and services sold to consumers, it avoids taxes on businesses by rebating the GST paid on business intermediate and capital inputs. However, under the current Indian system, many sectors are exempt — neither are taxes paid on sales, nor are there rebates for GST on inputs. When an exempt business sells goods or services to other businesses, the GST gets imbedded in costs and cascaded into higher prices for consumers. To avoid cascading GST on business costs, exemptions should be minimized to remove the blockage of indirect tax credits. Firms would no longer need to bear indirect taxes paid on business inputs, but could claim them back through credits set against business income.
With this in mind, we motivate our GST analysis by considering three scenarios. The first scenario is the current pre-GST system of indirect taxation. The second scenario is a more comprehensive GST, which we characterize as the ‘“stretched” GST because it is feasible by amending constitutional rules and “stretching” their scope. The stretched GST has no exemptions except for agriculture. The third scenario is the planned or real-world GST, based on media reports of the Government’s current thinking. We refer to this as the “truncated” GST because of exemptions for large sectors such as petroleum, natural gas, electricity and construction.
We assume a GST rate of 18% for the purposes of our analysis. This is one of five slab rates decided by the GST Council: 0% for essential items, including food; 5%, for common use items; 12%; 18%; and 28%. We selected the 18% rate because it is anticipated to be close to the average rate across all slabs.
Our comparison of METRs under the three scenarios is shown in Figure 1. The results are presented for all sectors and at the national level. The left-hand column is the current METR, the middle column is the METR under the stretched GST and the right-hand column is the METR under the truncated GST.
Figure 1: METRs under GST scenarios
In all sectors except agriculture, METRs are the highest under the current system of indirect taxes and the lowest under the stretched GST. This is to be expected because the stretched GST is explicitly designed to remove taxes on capital purchases. Overall, moving from the current system to the stretched GST reduces the METR from 27% to 17% — a significant improvement. The truncated GST leads to a 24% METR, which is a little lower than in the current system, but much higher than the stretched GST METR.
The result for the electricity sector is particularly notable, although the basic logic holds for the other sectors as well. The electricity sector currently has a low METR because of cost advantages from accelerated depreciation and initial allowances under the corporate income tax (CIT) and a wide range of indirect tax exemptions, particularly for large power-generating projects and renewables. The exemptions are widely viewed as beneficial but are actually harmful from an investment perspective because they raise METRs, as can be seen in the truncated GST, where benefits provided by allowances are counteracted by blocked credits. These blockages are removed under the stretched GST, leading to a sharp fall in the METR.
Our analysis, therefore, shows that the stretched GST is more beneficial than the existing system or the truncated GST from an investment perspective. Unfortunately, it appears that the stretched GST is unlikely to be implemented in India. Some sectors important to the economy such as construction and electricity are likely to remain exempt, inadvertently harming investment incentives.
Another concern from an investor’s perspective is India’s high CIT rates, which are among the highest in the world. Some investors, such as those in the electricity and manufacturing sectors, are provided relief through accelerated depreciation and initial allowances for qualifying capital. However, these allowances distort capital markets by discouraging capital to be invested in their most profitable use, as well as lead to a loss in revenue.
Given the costs of high CIT rates and allowances, we studied whether changes in direct tax rules affect India’s tax competitiveness or reduce the costs of incentives. Some METR results under the three scenarios are shown in Figure 2. For each sector, the left-hand column is the current METR. The middle column presents METRs when accelerated depreciation and initial allowances are removed. The right-hand column presents METRs when, after depreciation and initial allowances are removed, CIT and MAT rates are adjusted such that the national METR is the same as at present.
Figure 2: METRs under different CIT scenarios
As expected, the removal of depreciation and initial allowances raises METRs across the board. Since these allowances are most beneficial for machinery, the METR increase is most pronounced in the machinery-rich manufacturing and electricity sectors.
After removing the allowances, the METR can be lowered by reducing direct tax rates. Our analysis shows that CIT rates can be brought down from the current 34% rate to about 14%! MAT rates can also be brought down from the current 18.5% to 12%. These sharp decreases in statutory rates are possible because the removal of allowances, in effect, significantly expands the tax base.
The core message from Figure 2 is that a low CIT regime is feasible in India if depreciation benefits are removed. Instead of CIT and MAT rates of 34% and 18.5%, respectively, CIT rates of 14.2% and 12% could be offered. This would not much change the overall incentive for investment (because the aggregate METR does not change), but it would be a better signal to attract international investment as well as create more incentives to keep profits in India.
In summary, our analysis indicates that a GST reform has the potential to significantly reduce the costs of investment, which could be hugely beneficial to our economy. However, this potential can only be realized if the stretched GST were implemented with minimal exemptions. If, however, the truncated GST is implemented as planned, with exemptions for key sectors of the economy, then much of the gains from the reform would be lost.
Under the stretched GST, the need for many special tax breaks such as accelerated depreciation and investment allowances would be redundant. But even without the stretched GST, we show that it is feasible to significantly reduce the statutory CIT rate without changing the investment tax wedge, through the simple expedient of removing all special tax preferences. Both GST and CIT reforms would ultimately make India tax-friendly for investment and improve the prospects for economic growth.