How The Corporate Tax Cut Could Alter The 15th Finance Commission’s Math
The 15th Finance Commission in a meeting with economists, at the RBI headquarters in Mumbai. (Photograph: PTI)

How The Corporate Tax Cut Could Alter The 15th Finance Commission’s Math

BloombergQuintOpinion

In our earlier column, we had, among other things, opined that the reduction in the corporate tax rate will strain the centre’s fiscal deficit measures, given the centre-state revenue-sharing model and the devolution process being undertaken by the Finance Commission. In this article, we further elaborate this attendant consequence of the recent rate reduction.

The necessity of fine-calibration of rates, keeping in mind India’s competitiveness on corporate tax rates, cannot be over-emphasised in any manner. That said, these are multifarious factors that necessitate delicate balancing.

  1. The rate of tax has a direct proportion to the centre’s tax-revenues. meaning thereby that a lower tax rate could impact various government schemes.
  2. Conversely, higher tax rates do not automatically imply high tax collections or tax-buoyancy. High tax rates clearly are an impediment to investment, directly impacting the ability to reinvest, leave alone enhancing shareholders wealth.
  3. Given our constitutional scheme, the third relevant facet is the devolution mechanism whereby the states have a constitutional entitlement over a certain proportion of the central government’s tax proceeds.

An elaborate exercise by an independent constitutional institution, i.e. the Finance Commission, results in fixation of the revenue-sharing formula for a five-year period. To illustrate, the 14th Finance Commission recommended “increasing the share of tax devolution to 42 percent of the divisible pool”.

This can be roughly translated to mean that the central government gets to retain almost half as its share of tax revenue and must share the balance with states, though, there is no reverse obligation on the states notwithstanding their financial prosperity, if any.

Examined in this light, the new tax rates which shall have short-to-medium-term impact on overall collection brings to fore some intriguing insights.

What The 14th Finance Commission Laid Out

The recommendations of the 14th Finance Commission came into force from the financial year 2015-16. We examined the estimates made by the 14th Finance Commission and tax revenue expected to be devolved by the centre to the states. The projections of the 14th Finance Commission were as under:

Given that we now have the benefit of the actual tax collections, we undertook a comparison of the aforesaid projections with the Union Budget 2019-20 presented in July this year.

One can draw the following insights from these figures:

  1. The 14th Finance Commission had projected that states’ share will be Rs 7,72,304 crore, Rs 8,93,430 crore and Rs 10,34,745 crore on the basis of the centre’s revenue collection for FY18, FY19 and FY20, respectively.
  2. As against these, states received only Rs 6,73,005 crore in FY18 (as against Rs 7,72,304 crore) owing to centre’s revenue collection being below estimates. Further, the original estimate of the centre’s devolution of Rs 7,68,412 crore for FY19 was also revised downward to Rs 7,36,879 crore, as against the estimate of Rs 8,93,430 crore made by the Finance Commission.
  3. The Finance Commission had estimated the centre’s revenue collection for FY20 as Rs 27,63,456 crore and on that basis, estimated the devolution of 10,34,745 crore to states. However, as per the July 2019 Budget documents, the centre has estimated that it would only be able to collect Rs 24,58,714 crore.

The first two oberservations reveal that the estimate of the 14th Finance Commission regarding revenue collection were, in hindsight, inflated and did not match with the economic outlook. Rather, it did not forecast a slowdown. As a natural corollary, states would have had to carry out their fiscal obligations with less-than-estimated contribution by the Finance Commision.

The difference between the estimate and actual revenue collection of the centre will be a compelling factor for the incumbent 15th Finance Commission to be more circumspect—and perhaps even a bit restrained—in estimating the centre’s tax-revenue projections for the coming five years.

This may also be matched by a clamour from the states that the 15th Finance Commission increase the states’ share in the devolution formula, to make good the deficit of earlier years.

The third observation, however, has an entirely different facet. Even without the current tax rate reduction, it was evident in July 2019 itself that the centre will likely miss the FY20 revenue projection of the 14th Finance Commission, which automatically translates into a reduced share of devolution for the states. As per the press note accompanying the ordinance, the centre will further forego Rs 1.45 lakh crore owing to the revised tax rates. This, axiomatically, implies a further reduction in the devolution amount available to the states. Having said that, a deliberate act of the union government to forego such extensive sums of tax revenues is a material differentiator, as explained in the next section.

Impact On 15th Finance Commission Talks

The centre can, possibly, in its representation to the 15th Finance Commission, contend that the difference between the estimates of the previous commission and the revenue collection cannot be solely attributed to the center. This may apply even to the revenue forecast made in the FY20 budget. This does not hold true for the current rate reductions. The centre  cannot take a stand that it has no role to play in reduced revenue collection and therefore it is not accountable for a reduced devolution to the states.

Applying the 14th Finance Commission’s formula of 42 percent devolution, the centre’s current rate reduction implies a shortfall of Rs 60,900 crore for the states.

Given the substantial nature, states can surely be expected to escalate this aspect before the 15th Finance Commission. They might even seek an assurance from the centre, through the Commission, that the missed revenue forecast is on account of the centre’s conscious policy decisions, such as the tax rate reduction. That should nonetheless be recouped albeit in some form of compensation. The Goods and Services Tax compensation formula provides ardent insights, though that was part of the ‘grand bargain’ before states supported the GST constitutional amendment.

Former Finance Minister Arun Jaitley had described GST as a ‘federal contract’ wherein in the centre and the states had ‘pooled’ their ‘sovereignty’ and agreed to take decisions conjointly in the fiscal space of indirect taxes. For want of a better expression, this ‘bargain’ between the centre and the states was such that towards ceding their sovereign policy space in VAT, entry tax and other indirect taxes, the centre assured to compensate the states for any loss of revenue on account of transition to GST.

The terms of engagement were legislated by Parliament wherein each state was not just assured of the revenue (from indirect taxes) collected by it in the base year of FY16, but in fact the states’ entitlement was legislatively guaranteed for a year-on-year incremental growth of 14 percent. Any shortfall for the states in these guaranteed realisations is, under a legislative scheme, monitored by the CAG, and compensated by the centret. So far, there has been no instance of reneging by the centre and states have been unison in the GST policy framing, as reflected in the functioning of the GST Council.

The 15th Finance Commission may do well to imbibe the learnings of this successful fiscal-collaboration of the centre and states and recommend a similar synergised model in the devolution mechanism.

Such a scheme is also flexible to meet the demands of the special- and backward-category states, which require additional impetus for industrialisation and economic growth. Given that the reduced corporate rates are contingent upon forgoing exemptions, backward-area tax incentives may not be sufficient to induce industries to set-up in such states. Thus, employment generation, infrastructure build-up and the consequently enhanced economic activity in such states will require additional features to be incorporated in the policy design. This contingency is expected to play highly in the deliberations of the 15th Finance Commission. A creative, yet acceptable, solution may have to be found to address the inter-regional disparities.

Silver Lining

While challenges on the fiscal deficit front are indeed a relevant consideration, the is a silver lining:

  • The rate cuts will apply to public sector undertakings and hence the profitable ones can be expected to contribute more to the government’s finances and address the strain on centre’s finances to some extent. This may be particularly true in case of oil PSUs, utilities, profitable banks, who are in better financial health.
  • The 14th Finance Commission did not have the benefit of factoring GST revenues. Such trends are available for the 15th Finance Commission, which may consider the increased revenues available to select states (on account of GST collections along with the compensation) as a reason not to further enhance the Union’s share in devolution.
  • More crucial is the dimension regarding the recent expansion of the Terms of Reference of the 15th Finance Commission and the consequent assurance given by it to the Ministry of Defence that it will consider measures “to increase the overall capital space of the Ministry, bring about predictability and help the Ministry in its defence preparedness”. Addressing this novel demand of a specific ministry of the centre may led to subtle changes in the devolution mechanism recommended by the 15th Finance Commission.

Summary

Overall, it is evident that the realignment of the corporate tax rates is not a uni-dimensional move and that it has far-reaching ramifications, more particularly in the constitutionally delineated scheme of centre-state financial relations. There is no need to over-emphasise that the goal of having a $5 trillion economy by 2025, which also coincides with the term of the 15th Finance commission, cannot be achieved by the centre alone. States need to be participants in unision. This puts the 15th Finance Commission in an unenviable position. It must not only be a harbinger of India’s economic growth and progress, but also lay a realistic roadmap to attain this pioneering vision.

Mukesh Butani and Tarun Jain are Partners at BMR Legal.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.

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