Can Tax Cuts Breathe Life into India’s Economy?

February 19, 2014 Posted by India Briefing Reading Time: 4 minutes

By Wiebke Szymczak

The government’s interim budget plans promise tax cuts, recovering growth and the reduction of India’s fiscal deficit, but are they enough to revive the economy before elections in May?

Earlier this week, India’s Finance Minister Palaniappan Chidambaram presented the government’s interim budget plans, unveiling a package of indirect tax cuts. After facing what many have called the economy’s ”worst slowdown in nearly a decade,” the government’s new budget plans may be a first step towards reviving economic growth in India.

While Chidambaram was demonstrably worried about the deceleration of manufacturing investments, terming it the Achilles’ heel of the Indian economy, he emphasized the “stellar performance of the agriculture sector” and the sharp recovery of exports despite declining overall growth in global trade. He attributed these achievements to several notable government decisions that were “courageous and long overdue,” such as the correction of diesel prices and the deregulation of sugar.

Moreover, he pointed out that the “bold step to set up the Cabinet Committee on Investment and the Project Monitoring Group” was key to solving inefficiencies in project administration, thereby clearing the way for the completion of 296 projects with an estimated project cost of INR6.6 trillion (US$106 billion).

With regard to the interim budget, Chidambaram announced that the fiscal deficit for the current financial year would be contained at 4.6 percent of GDP compared to 4.9 percent of GDP in the previous financial year. While he does not want to break with existing conventions by changing tax laws in an interim budget, he believes that the current economic situation calls for immediate intervention. Therefore, he suggested that factory-gate taxes on some capital goods and consumer durables would be reduced to ten percent from 12 percent, and excise duties on small cars, two wheel and commercial vehicles would be cut to eight percent from 12 percent.

In addition, he proposed to make reductions in the excise duty on chassis and trailers. Given that car sales in India have dipped to a 10-year low, a reduction in indirect taxes on cars may in fact help boost economic growth.

With elections approaching in May, it is not surprising that the government is choosing to shy away from more drastic changes so as not to provoke any controversy. “The finance minister may offer some sops including in taxes but [he is] unlikely to make any big changes at this stage as it would be controversial ahead of elections,” said a senior government official.

However, opinions diverge about the credibility of the government’s spending plans. Some analysts express doubts regarding the government’s ability to keep the fiscal budget deficit within 4.8 percent of gross domestic product. They predict reductions in government spending would be needed, which may have a contracting effect on growth.

According to Moody’s, while the Indian government has demonstrated a commitment to meeting its deficit targets, spending cuts are also likely in order to constrain GDP growth in the current year. Global rating agencies like Moody’s, S&P and Fitch have repeatedly threatened to lower India’s credit rating in recent months. A downgrade would mean pushing the country’s sovereign rating to junk status, making overseas borrowings by corporates costlier.

In light of the government’s interim budget plans, however, the rating agency refrained from previous threats, and is apparently willing to maintain India’s current Baa3 rating with a stable outlook.

Nevertheless, the situation remains uncertain and several polls indicate the current government will lose the upcoming elections in May. Unless it manages to get the proposed tax cuts approved by parliament in the coming weeks, the interim budget plans presented Monday are likely to be overturned in June, and will thus have a limited effect upon India’s economy. On the other hand, Chidambaram has already indicated he might push the changes through with an administrative decision that doesn’t require parliamentary approval, following the example of former finance minister Pranab Mukherjee in 2009.

In any case, Chidambaram took an important chance to highlight achievements and progress in areas of rural development, social sector and welfare programs such as food security and employment guarantees introduced by his government over the past 10 years. Thereby, he addressed previous criticism accusing the government of “policy paralysis”. The upcoming election will ultimately indicate whether he was able to restore voters‘ and investors‘ trust in the government‘s economic policies, however.

Regardless of the recent discussions, the Indian economy’s overall prospects appear to be lightening up, raising hopes that the slowdown will be coming to an end soon. Given India’s current economic situation, a path towards further liberalization, economic deregulation and expansive fiscal policy is likely to continue regardless of whether the UPA, BJP or even the AAP come to power in the upcoming elections.

A complete version of P. Chidambaram’s speech is available here.

Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.

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