Corporate tax cuts – sets it up nicely between the bulls and the bears

First rains after a long drought.... bulls on a rampage..... bears struggling to find a cover.... atleast for now !

In a bid to revive the struggling Indian economy, the Finance Minister (FM) announced a major overhaul of the Indian corporate tax system on Friday (September 20, 2019).

  • Effective Tax Rate (ETR) reduced from 34.9% to 25.17% for existing companies;
  • ETR lowered further to 17.01% for new manufacturing units set up after October 1, 2019 (upto March 31, 2023) ; and
  • Minimum Alternative Tax (MAT) removed/ lowered across categories

Also, the high surcharge on stock market capital gains introduced in FY20 budget has been withdrawn.

Corporate tax cuts is the most significant announcement out of a slew of reforms the FM has announced over the last one month

Government previously announced many measures including tax surcharge reversal for Foreign Portfolio Investors (FPIs), liquidity measures for banks and NBFCs, merger of Public Sector Banks (PSBs), interest rate cuts to boost consumer demand, auto sector specific policy changes, income tax procedural improvements, FDI simplification, boosters for housing and export sector etc.

However, none of these measures could infuse the much needed momentum and positivity in the businesses and/ or the capital markets. My previous notes on some of these measures – 

FM responds, market reacts – where are we now? – dated August 26, 2019

Public Sector Banks Merger – Key points to note – dated September 3, 2019

Since the announcement, Nifty has increased by about 9% in 2 days and is now only 4% away from the all time highs.
There is a lot of optimism amongst investors in general and most are calling it the second greatest reform in the Indian history after liberalization of 1991.

Personally, I do agree that it’s a bold and much needed move, that can do wonders to the long term fortunes of our country.

Impact on stock markets? The factors that I am considering

1. Rationale to cut the corporate taxes

Lower corporate taxes was a long pending demand from the industry and the investors.

This is both from the perspective of incentivising domestic businesses to expand and attract foreign companies to set-up businesses in India.

ETR of 25.17% for existing Companies and 17.01% for new manufacturing units is highly lucrative and completely changes the rules of the game. I can surely imagine many Companies already drawing plans to set up new facilities and many so creatively !

Post tax cuts, we have also become one of the cheapest compared with the other developing economies.

This along with our large english speaking manpower should draw significant interest from the global manufacturers. Land availability, supporting infrastructure and regulatory approvals are the other key factors that would determine the success on this front.

2. Impact on corporate earnings and balance sheets

This is the direct result of reduced taxes. Ideally, lower tax means lower cash outflow and higher reported earning that in turn lead to higher earning per share (EPS), reduced debt and stronger balance sheet.

Since Friday, there have been various opinions on the quantum of impact that reduced taxes will have on the reported EPS of various Companies and the index. The estimates for Companies vary from 0% to +29% and for Nifty +10%.

Points that I am considering to try gauging the impact – 

  • The impact as per me on any Company should only vary between 0% to 15% and anything more would be due to the accounting adjustments which should ideally be ignored to calculate a true EPS. 0% when the existing ETR is less than 25.17% (revised maximum rate) and 15% when the existing ETR is at current maximum of 34.9%.
  • Given the current economic slowdown, I don’t expect all the savings to translate into the higher EPS.
    • Consumer and Auto companies may reduce prices and/ or focus on increasing marketing spends.
    • In Pharma sector, it might lead to increased R&D spends.
    • In Government regulated/ dependent businesses e.g., oil marketing, savings can leak through tighter price control. Likewise in infra sector, the government contracts might come at lower prices.
    • Banks may decide to pass some towards higher marketing or retail customer acquisition costs (e.g., cash backs)

I don’t recommend that we should assume every penny saved through lower taxes to translate into higher earnings, especially in the short term – given the current economic slowdown and upcoming festive season.

Yes, agreed that the announced cuts are going to positively impact the profits for ever and accordingly the fair values should be revised upwards. However, for now I would revise assuming maximum of 50% benefit to accrue towards EPS accretion – so maximum of 7.5% higher EPS. I may revised this upward as economic situation revives.

3. Sentiment booster for the promoters and the stock market bulls

This I believe is the most important impact of the announced tax cuts on an immediate basis. 

Promoters and businesses are the happiest lot. Their long pending demand has been met. They get liquidity that can be utilised for varied purposes – business growth and expansion, debt repayment, rewarding employees.

Stock market bulls – finally get an important weapon to fight the bears. The stock market reaction over the last couple of days is testament to this – bulls are on a rampage and bears looking for cover. Nifty recorded the second best day on Friday in last 10 years and has increased by 9% in last 2 days. It’s now only 4% away from the all time highs.

The beauty of this weapon for bulls is – it’s real (a major policy action) as well as hope (needs time to unfold).

Unless the economic or external situation worsens drastically, bulls can continue to use this to scare off bears !

4. Economic situation may need some quick fix demand side solutions

The current economic slowdown is primarily a demand side issue vis-à-vis supply side constraints.

Please refer my pre-budget note Expectations from Budget 2019 – a common man’s perspective ! for what I believe are the reasons for the slowdown.

Announced tax cuts make the supply side happy. Agreed that some of this will transmit towards the demand side – lower product prices, higher employee salaries, expansion driven new employment generation and so on. However, most of these measures will take time.

Price cuts is the only immediate demand side transmission that I can currently think of. Extent of the same remains to be seem.

5. Implications for the fiscal deficit

Government estimates tax revenue loss of Rs 1.45 lakh crore due to the announced tax cuts. This would directly increase the budgeted fiscal deficit for FY 20 from 3.3% to 4.0%. However, NITI Aayog (Government’s policy think tank) expects the impact to be much more limited – tax cuts to prompt increased economic activity and hence higher tax collections.

As a stock market investor, I am keen on fiscal discipline but not extra obsessed with it.

Few basis points I don’t believe make as much difference as it is sometimes publicised. Yes, it has interest rate implications but then we can’t just keep on focusing on one factor ignoring other variables.

I also believe, Government would be able to manage the fiscal deficit within acceptable limits by putting greater focus upon –

  • Tax compliances – with reduced rates this becomes more easily enforceable now
  • Divestments in public enterprises 

One important point to mention here is – crude price related shocks. It especially becomes important given the ongoing dispute between Iran and Saudi Arabia. Although, India has got assurances to get the requisite supply of crude at right prices, if the dispute gets escalated, it can have significant implications for the Indian economy and the fiscal discipline.

6. Other important factors

Tax rate cuts have helped mitigating the concerns around domestic economic situation. Consequently, the interest seems to be reviving in the domestic stock markets…. at least for now.

What one also needs to keep in mind are certain other important internal and external factors as I have been consistently mentioning in my previous notes. These include – Kashmir issue, global growth concerns, Hong Kong protests, Brexit uncertainty and US getting into an election year with a very unpredictable sitting US president.

We cannot move in isolation to the global markets – especially if the latter were to correct significantly.

The long awaited tax cuts are now a realty. Government has provided the much needed sentiment booster to the promoters and the stock market participants. 

What promoters do with saved taxes, remains to be seen. Meanwhile, bulls are running wild and bears waiting anxiously !

“There is nothing riskier than the widespread perception that there is no risk.” — Howard Marks Click to Tweet

“The stock market lives longer than anyone of us. Therefore, don’t trade all your capital like there is no tomorrow.” — inspired from Benjamin Lee Click to Tweet

Disclaimer: These are my personal views and not any recommendation. The reader should do his own research before making any investment related decision.

Illustration Credit: Vecteezy.com

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About the author

Nitin Jain

A finance professional with around 20 years of investing experience in Indian markets both on buy and sell side, equity and debt, private and public with some of the best organizations globally including Goldman Sachs, ICICI Group, ICRA and others. He is a All India Silver Medalist CA by qualification.

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Amit jain

I would like to suggest if the corporate and personal tax are put at a straight 10%, and import duty from China is increased sharply, then may be our economy will see a huge growth and the increased gdp will cover all the fiscal deficits.

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