By Indranil Sen Gupta & Aastha Gudwani
can the union government income tax rates too as some media reports suggest? We think that the bar is pretty high, despite the recent Direct Tax Code report recommending it. Its new tax slabs, as reported in the media, would likely cost Rs 1750bn/$25bn/ 0.8% of GDP, a top 0.7% of GDP released by September's corporate tax rate cut. There is no doubt that a demand-side measure, like the income tax cut, has a more immediate growth impact than a supply-side measure like the corporate tax rate cut, in our view. Along with RBI measures, this would help to defuse the 2018 liquidity crunch that has pushed up lending rates and hurt demand. On our part, we see three pre-conditions for Delhi to cut income tax rates now: 1) muted Diwali festival demand; 2) banks not passing on RBI rate cuts even after linking retail/SME loans (~40% of bank book) to external benchmarks like the RBI repo rate; and 3) greater comfort about funding the fiscal gap. This could come from the ability to step up RBI OMO if FPI flows do not revive or quick privatisation. On balance, we expect the RBI MPC to cut 25bps on December 5, pause as growth/inflation goes up on base effects, and if global growth slows, cut another 40bps to 4.5% by September.
Income tax cut directly spurs demand
The recent Direct Tax Code has proposed cuts in both income and corporate tax rates. After September's substantial corporate tax rate cut, media reports suggest that Delhi can cut income tax rates as well. We estimate that the Direct Tax Code's new income tax slabs, as reported in the media, will likely cost Rs 1,750bn/$25bn/0.8% of GDP. Rs 1,000bn will be borne by the Centre and Rs 750bn by states in line with the 58:42 devolution ratio. The corporate tax rate cut that could take 2-3 years to take effect. Along with RBI easing, income tax cut would help to defuse the 2018 liquidity crunch that has pushed up lending rates and hurt demand. While the corporate tax rate cut should theoretically spur investment, businesses will expand capacity only if they see demand picking up.
Pre-conditions: weak Diwali, sticky lending rates, RBI OMO
Muted Diwali festival demand: Investors should track retail sales into the October 27 Diwali festival. Our auto analyst expects multiple discount schemes to sell passenger vehicles and two-wheelers in the festive season. Our consumer analyst also expects consumer companies to offer promotion schemes.
Weak transmission even after external benchmarks: We think Delhi will look to cut income tax rates now if banks do not pass on the 25bps October 4 RBI rate cut even after linking retail/SME loans (~40% of bank book) to external benchmarks like the RBI repo rate. Media reports suggest that some banks are already reducing lending rates.
Funding corporate rate tax cut: A quick income tax rate cut would likely be feasible only if Delhi gets comfort about financing the corporate tax rate cut that should lead to fiscal slippage of 50bps of GDP . Besides privatisation, this can take 2 forms: Step up in RBI OMO if FPI flows do not revive. FPI inflows, at $2.5bn FYTD, are running well below $12.5bn FY20 BofAMLe. Use of RBI surplus capital: The MoF could meet the fiscal gap utilising RBI's surplus capital (Rs 520bn) identified by the Jalan committee and interim dividend.
(Edited excerpts from BofAML's 3 pre-conditions for income tax rate cuts dated October10, 2019. Sen Gupta is Chief India economist, and Gudwani is India economist, BofA Merrill Lynch. Views are personal)