(This is a slightly edited copy of Investor Memo shared with subscribers of Stalwart Advisors’ Model Portfolio)
The corporate tax rate (including cess & surcharge) in India has been slashed to 25% from earlier 35% giving a stimulus of Rs 1,45,000 Cr ($20bn). This is a flat rate with no further incentives; companies which are already enjoying some incentives like export-oriented plants or R&D expenditure etc. would have to let go of those benefits if they want to switch to this rate.
This is applicable retrospectively with effect from 1st April 2019, so current year’s (FY20’s) profitability for corporate India goes up roughly by Rs 1,45,000 Cr. For companies which were paying full tax at the rate of 35%, their post-tax annual earnings go up by 15% with a commensurate rise in their return on equity, ceteris paribus (assuming everything else to be equal).
What matters now is how this extra capital, in the hands of corporate India, is put to use:
1) In competitive industries or ones facing a slowdown, companies would most likely pass it on to the consumers in the form of lower product prices to induce demand.
2) Some businesses could use this bonanza for reducing debt on the balance sheet.
3) Others might plow it back in the business via capital expenditure to increase installed capacities and grow the business, leading to job creation.
4) Remaining businesses could either simply retain this surplus on balance sheet or share with stakeholders – with employees via bonuses and/or with shareholders via dividends/buybacks.
Impact on Portfolio Companies
This specific policy announcement has benefited large corporations more than smaller ones (up to Rs 400 Cr in annual turnover), which were already enjoying a lower tax rate of 28.5% (all-inclusive) as per Finance Bill 2019. This is why the market reaction for small- & micro-cap companies have been relatively softer as compared to mid- & large-caps.
Incremental benefit for some manufacturing and exporting companies which were anyways enjoying exemptions, incentives or rebates would also be limited.
Nine of our portfolio companies paid close to full tax (35%) in FY19 and could see a commensurate jump in after-tax profits and return on equity. In terms of weightage, these constitute roughly 50% of the model portfolio.
Impact on Economy
The much bigger, long-lasting and decisive policy announcement is, however, that of 15% tax rate on new manufacturing setups incorporated on or after 1st Oct 2019 and commence production before 31st Mar 2023. Even though the Make-in-India movement was officially launched on 25th Sep 2014 but the first major step to drive this forward has been taken exactly five years later on 20th Sep 2019.
There are trade tensions going on between the US (the largest importing nation in the world) and China (the largest exporting nation in the world) wherein both are trying to negotiate better terms for themselves. South Asian countries stand a once-in-a-lifetime chance to get a boost by attracting manufacturing capacities however India has been losing out due to steep taxation which was highest among competing peers like Vietnam or Bangladesh. Fortunately, with this tax cut, we are now at par and in some cases even more attractive.
Last couple of years global supply chains got disrupted due to internal issues in China including strict enforcement of environmental policies which led to shifting or closure of various manufacturing plants across the country especially in polluting industries like steel and chemicals. The obvious result was skyrocketing prices of various commodities but what hurt more was lack of timely availability which disrupted production schedules. This was a wake-up call for many businesses solely dependent on China to de-risk their supply chains and add alternate sourcing even if the costs were slightly higher than China.
India is one of the most attractive destinations due to abundant and cheap labor. China has had double-digit wage inflation for last decade as against almost stagnant wages in India – today average Chinese labor cost $700 per month as against $200 in India, even after adjusting for productivity difference the Indian wages are 60-70% lower.
With lower tax rates, if we are able to attract large MNCs like Apple and Foxconn to set up manufacturing in India, it will be such a game-changer for our economy. For it will not only create jobs and give livelihood to millions of Indians but also reduce our dependence on imported goods, saving the precious foreign exchange and reducing pressure on current account deficit. To make economic sense, some of the setups could be very large and even target exports out of India which will prove to be doubly beneficial.
We are a nation of 135 Cr people, the second most populated in the world after China, which could successfully leverage its ‘demographic dividend’ riding the manufacturing boom and becoming the factory for the entire world. However, now when our time has come, world is moving to automation, robotics, 3D printing, artificial intelligence, and whatnot. If we fail to create two crore new jobs every year for our youth, this ‘demographic dividend’ could become ‘demographic curse’ and implications for society at large will be catastrophic.
Ensuring the success of Make-in-India movement is our only chance to avoid that unfortunate outcome, and the tax cut is the step in the right direction. Putting profitability jump, RoE expansion, resultant stock market movement, and other short term implications aside, let us hope as a nation we are successful in achieving the desired outcome of job creation. Amen.