India's corporate earnings key to faster economic recovery

The last couple of months have witnessed an unprecedented recovery in the stock markets amid economies trying to get back to pre-Covid-19 days. The trend has been robust across most stock markets in the world. Stock markets have recovered faster than the economies. There is a divergence between the Main Street and Dalal Street in India. The last couple of days have seen some moderation in Indian markets as concerns around the budget heightened uncertainty and unverified reports of taxes have led to a bearish trend.

This is the usual pattern, when market trends before the annual budget give a signal to policymakers. The signal is one of hope and anticipation of faster economic recovery in India as many expect corporate earnings to improve significantly over the next business cycle. There are reasons why markets are roaring even as economies are yet to recover from the pandemic. Markets across the world tend to be forward looking. And, India is no exception. The bull run can be attributed to future income streams on the back of an economic disruption that was induced by the pandemic in this financial year that ends on March 31.

However, a direct consequence of this divergence are concerns about the ability for the bullish streak to be self-sustaining. There are concerns whether there will be a correction in the stock market. Conventional wisdom suggests that the correction is a natural outcome, but such a theory has gone for a toss in one of the darkest years in the history of mankind. The bull run can be linked to high levels of liquidity because of unprecedented fiscal stimulus by countries across the world. Low cost of capital enables people to take on riskier bets and the money finds its way into stock markets.

However, the impact of such measures on the real economy comes with a lag. But stock markets are able to respond instantaneously to these changes. The bourses are betting on stimulus. Asset prices are also tracked closely by central bankers, as it serves as an important mechanism for monetary transmission. The case of emerging markets is interesting, particularly for India, as it has received significant attention from foreign investors over the last couple of months. This attention has come in the form of both foreign direct investments (FDIs) and foreign portfolio investments (FPIs), as investors appreciate the reforms that were undertaken in the country over the last couple of months. This renewed interest also reflects an underlying long-term trend of more investors turning bullish on India over the medium to long-term.

India is the only viable alternative to China, as the country has the ability to add millions into its middle-class net over the next decade in its bid to become more prosperous.

Markets are looking far ahead amid the Covid-19 challenge.

There’s a caveat, though. Taxes in India, especially for the financial services, tend to be increased with every budget. However, entertaining the proposals of increasing taxes or introducing a tax on unrealised gains can have adverse implications for an economic recovery. The recent sell-off is a bid to communicate this sentiment to the government. The big bang in the budget will do no harm. No new taxes or an increase in tax rates top the wish list. The government has over the years tried towards rationalising direct taxes, and last year’s budget is a case in point. However, the peak tax rates have remained at the level they were in 2019 after the introduction of the super-rich surcharges.

Similarly, while the tax rationalisation of peak rates was not followed through. The government removed the dividend distribution tax while charging an income tax at applicable rates on the dividend income. This, too, resulted in an increase in tax rates applicable on dividend income for most of the people.

A vibrant financial sector calls for a taxation and regulatory structure that enables its growth. There is significant value addition in the economy which could be taxed at the applicable rates to generate more revenues than by increasing tax rates. This is important when we consider certain proposals to increase long-term capital gains (LTCG) to mop up additional revenues due to the stock market rally or the proposal to tax unrealised gains in stock markets. The first proposal is problematic because India has both, securities transaction tax and LTCG — one of them must be done away with as STT was introduced because LTCG was not applicable on equities. Since then, India introduced LTCG but securities transaction tax (STT) continues for some reason. Even if the issue of two taxes are ignored, an increase in LTCG would result in significant negative sentiment — and there may be no capital gains left to tax in the first place. The government may receive a lower revenue from increasing the taxes than keeping them constant. As the saying goes, if it ain’t broke, don’t fix it. The second proposal on unrealised gains is far more dangerous – as it is an attempt to tax income that has not yet even been realised.

Stock markets are volatile, and share-prices tend to move depending on the fundamentals of the company, sentiment about it and speculation about its future. Taxing unrealised income is against the principles of taxation and amounts to penalising wealth creation.

India must bring more people under its taxation net. People have reposed faith in India’s ability to recover faster and add millions to the middle-class basket is also contingent upon the extent of wealth creation that is likely to unravel over the next decade. It’s important to realise that not just capital but labour, too, is mobile as high taxes on the rich can result in them relocating to other locations. American billionaire Elon Musk is a case in point, as he has shifted his base from California to Texas. It’s a prudent strategy to keep internationally competitive rates and enable economic growth which, in turn, should more than cover for India’s welfare commitments.

The present budget has a very modest set of wish-list from market participants who are concerned about an increased burden of taxes.

However, there are several low-hanging fruits available for the Indian government that can ensure faster development of the financial services industry. India has a significant amount of human capital that can be tapped into by the sector and this could be the next outsourcing story.

Companies have realised that remote working can function well. What’s preventing outsourcing some of these profiles to low-wages, high-skilled people in emerging market economies? India’s manufacturing and high-value services outsourcing sector can add significant value to the economy. India can overhaul its taxation structure but also relook at some of its regulatory structure overhaul. The High-Level Advisory Group (HLAG), headed by Dr Surjit S Bhalla, made many of these suggestions. The panel argued creating a system that will ensure that foreign investors need not even visit India to set up a trading account.

The present rally of Indian markets is based on these trends as they expect a greater share of high-value additional economic activities. Also, there is a global pool of surplus liquidity.

The divergence between the Main Street and Dalal Street is yet to become a talking point. But it may snowball into a raging row, if the Indian government fails to undertake some of the reforms that are needed to kickstart the economy in a post-Covid-19 world.

The stakes are indeed high. Rapid correction of markets — whether in India or the US — will have catastrophic implications for the global financial system, which will slow the pace of economic recovery. India has committed howlers such as the retrospective tax amendment in two high-profile cases — Vodafone and Cairn — and ended up eating the humble pie.

The government must admit that the law was in bad taste and accept its mistake. It followed with another blunder: the introduction of LTCG even as STT remained. Piecemeal tax reforms tend to add to uncertainty and distort the entire taxation structure. A complete overhaul of the tax code along with rationalisation of tax rates is the need of the hour. On September 20, 2019 the government had delivered a surprise corporate tax cut to boost the economy. Sitharaman had said the base corporate tax rate would be lowered to 22 per cent from 30 per cent. The surprise move had triggered a stock market rally, as the benchmark Sensex index jumped 4.5 per cent. The tax cuts aimed to boost spending and shore up investments in the country.

Let’s hope India’s Finance Minister Nirmala Sitharaman keeps the market sentiments in mind, as the nation eyes to clock an eight per cent growth.

Karan Bhasin is a New-Delhi based economist with research interests in political economy, macroeconomics, monetary policy and new institutional economics