Given that the Union Budget is round the corner, discussions relating to taxation have come to the fore. In this context, we examine the real effects of the corporate tax cut implemented in September 2019. We find that the tax cut resulted in an economically meaningful 7 per cent additional investments by beneficiary firms.

Although an extensive literature has looked at the real impact of taxes and, by extension, of tax cuts, there is no consensus on even an issue as fundamental as the incidence of tax — in other words, economists disagree on whether capital or labour bears a higher incidence of tax. Most papers examine the US tax cuts of 1986, 2001, 2003, and 2017.

A survey by economist Alan J Aurebach, published in the Journal of Economic Perspectives, summarises this line of research. The findings range from mild positive effects of tax cuts on wages and investments to practically no effect. Not surprisingly, many scholars whose views on tax cuts are based on the above research do not find merit in tax cuts.

Last year’s Economic Survey had convincingly argued that the relationship between economic variables may be different in India compared to developed countries. For instance, the Survey showed that, unlike in developed countries, economic growth in India influences poverty and other social indicators.

Similarly, one may argue that tax cuts could stimulate corporate investments in a credit-constrained environment. In other words, in a situation where firms have valuable project ideas but are unable to get funding from financial markets, increasing the net cash flow in the hands of the firms may lead to higher investments. We test the above hypothesis.

We compare the investments of firms that benefited more (treated) from the tax cuts with those that benefited less (control). To avoid the look-ahead bias, we identify the two groups of firms based on their effective tax rates in 2018-2019. Note that firms that paid a higher rate of taxes before the tax cut benefited more. We also use the stock market reaction to the announcement as an alternative identification strategy.

We find that the assets of the firms belonging to the treatment group grow more than that of the control group. As an alternative measure of investment, we examine the change in the value of property, plant, and machinery. We find that firms benefiting more from tax cuts invest 10 per cent more than other firms after the tax cut.

To address the concern that the results are due to some other inherent differences between the two groups of firms, we limit our sample to (i) listed firms, and (ii) firms belonging to the NSE 200 index. We also match the treated and control groups based on several firm-level characteristics such as size, sales growth, and profitability.

The idea here is that the firms in these sub-samples are likely to be, on average, similar on other dimensions that impact investments.

We continue to find that the firms that benefited more from tax cuts invest more in asset creation after the tax cuts.

It is important to note that our research design allows us to capture only the difference in the investment of more and less impacted firms. Investment by one set of firms could have positive spillover effect on other related firms and industries.

A higher investment contribution from the internal accrual of firms may also raise the comfort of lending institutions and other financial market participants in funding projects. In addition, tax cuts could have influence employment, wages, prices, and other variables. Thus, a more comprehensive examination is needed to reveal the full impact of the tax cut.

Important role

However, given our results, it is reasonable to conclude that the corporate tax cut did play an important role in the revival of the private capital expenditure that is ongoing. Although the tax cut was not announced as a Covid response measure, it seems to have played an important role in ensuring corporate sector resilience to the crisis.

It is noteworthy that although beneficiary firms paid a lower tax rate, they ended up paying significantly more taxes within a year than before the tax cut.

It is hard to estimate the level of taxes such firms would have paid without the tax cut. Given that all firms in the economy are expected to be impacted by, and react to, the tax cut, it is hard to estimate the true counterfactual.

The increase in taxes also suggests that the government’s simplistic approach in estimating the “taxes forgone” may not be economically valid. The second-order effects of increased income through increased investments may dominate the first-order loss due to a reduction in the tax rate.

The crucial policy lessons go beyond the immediate benefits from a tax cut.

First, a clear policy not obfuscated by the fineprint is likely to deliver the intended outcomes. Second, as repeatedly emphasised by the recent economic surveys, policies in India should be guided by thinking based on first principles. Importing inferences drawn using developed country settings to Indian policy-making may lead to missed opportunities.

Finally, any relaxation should be economically meaningful to have a direct and immediate impact. We hope to see many such measures in the coming Budget.

The writers are with The Indian School of Business

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