Not in a straight line

The corporate tax breaks are now three weeks old and as far as the news cycle and the stock market hype cycle goes, it is old news. In the hours after the announcement of the tax break by the Finance Minister on Friday, September 20, stock prices shot up almost indiscriminately. I say 'almost' because even in the heat of the moment, companies that would not benefit from the tax break were more or less excluded from the rally. The following Monday saw another big jump and although after that, stock prices have paused and wandered around a bit, for the most part they are substantially higher. Meanwhile, the corporate tax cut has sunk into the general background noise of the so-called news that keeps supplying the daily flow of reasons that purportedly explain waxing and waning of stock prices.

One could almost be forgiven for believing that the tax cuts were just another item in this daily flow, fitting somewhere between the latest titbit from the trade war and the warlet in the middle east. On a cursory glance, which the punters probably gave it, it looks like a bonanza amounting to up to 15 percent of extra profits for companies that are paying a high tax and that's that. The stock prices of those companies should go up by 15 percent and that was what has happened, more or less. Beyond this, there is the official logic of the tax cuts improving businesses' capacity to invest and of making India more attractive as a manufacturing base.

However, the story doesn't quite end even there. The tax cut will have a far reaching impact on businesses in India. The impact will accumulate, and keep accumulating far into the future. There will be immediate direct effects but there will also be second and third order effects which will eventually be more powerful. Some of these second and third order effects will have counterintuitive effects and there are businesses that will actually be negatively impacted by the tax cuts on a relative basis.

Take even the simplest effect, that of increased profitability. At Value Research, our Stock Advisor analyst team has built a model to tease out what the impact will be beyond just paying less tax this year. Even assuming that everything else stays constant, over a five year period, the cumulative impact of the tax cuts would be almost a doubling (+88 per cent) of the profit from the current level. Obviously, some will be lower and others will be more, even far more. Businesses that have a higher effective tax rate today will get a proportionately higher benefit.

Then come the second order effects. Some of these businesses will reinvest the profits. There are businesses which get a higher return on the funds they invest. Those businesses which have a higher effective tax rate today, plus a business structure that gives them potentially higher return on money that they plough back into the business will have a disportionately high benefit.

The caveats here are obvious. All this assumes that businesses will choose to make more profits. That may not be true in all industries and for all companies. Given the demand squeeze, many of them could instead opt to use the tax cuts to drop prices or otherwise spend more to push sales instead of boosting profits. These companies may have competitors that may not be able to do so because of other constraints they have. This would mean that the tax cuts may actually render some companies less competitive relative to their competitors.

There will be even more indirect effects down the line. The lower tax rates, especially the 15 per cent rate for new manufacturing units should eventually lead to new investments that will completely change the landscape in some industries. How will that impact existing businesses? I would say that at this point we are very far out on a limb and even the approximate impact cannot be hypothesised. All one can say is that at the end of the day, the impact on the economy will be deeply beneficial, but the straight line projections that the punters are making today will certainly be wrong.