Corporate Tax Rate Cut: FM’s Master Stroke brings in Diwali cheers

Santa-(raman) sends early Diwali Gift

FM Nirmala Sitharaman’s decisive step to pump-prime the economy after a series of baby-step reforms brought cheers to the market. Corporate head honchos contemplate this move as a strong signal that the incumbent government is prepared to take bold steps to revive the economy. This stimulus will not only provide a much-needed respite from the economic slowdown but also help kickstart the next big virtuous economic cycle by reviving the Capex and market sentiments.

Corporate tax rate slashed for domestic companies

The Government allows any domestic company to pay income tax @22% provided they will not avail any other tax exemptions or incentives. The effective tax rate inclusive of surcharge & cess for these companies will come down to 25.6% from 34.9% earlier. In addition, such companies shall not be required to pay Minimum Alternate Tax (MAT). 

On the other hand, in order to attract fresh investment in manufacturing sector under ‘Make-in-India’ initiatives, new domestic companies incorporated on or after 1st October 2019 have the option to pay income-tax at the rate of 15%. The effective tax rate for these companies shall be 17.01% inclusive of surcharge & cess.

Likely to unleash the lost corporate animal spirit

One of the biggest challenges of Indian economy impacting the Capex (investment) has been the decline in corporate savings. Detailed analysis of BSE-500 companies shows that Corporate profit-to-GDP ratio has declined from 4.7% in 2007-08 to around 2% now. The sharp cut in the corporate tax rate is likely to augment the corporate earnings, which in turn, will create room for companies to commence definite capital expenditure (Capex) plans. 

Rs.1.45 trillion worth of fiscal stimulus is likely to reboot the slowing economy by kick-starting a virtuous cycle of investment and spurring consumption growth. We believe this bold move is likely to unleash the lost corporate animal spirits.

Source: Bloomberg, BSE, DreamLadder Capital Research

‘Make-In-India’ to get a boost

The world has been moving towards lower corporate tax regime. As per the KPMG, the average corporate tax rate for Asia has declined from about 30% in 2003 to about 23% in 2019. However, we saw the opposite trend – a marginal increase during the last decade in terms of an effective corporate tax rate, making us uncompetitive, vis-a-vis Asian Tigers.

The lower tax rate will make India a more attractive investment destination from across the globe along with improving the competitiveness of our private sector, thus providing the much-needed impetus to the manufacturing sector. This would also help attract the companies and business opportunities shifting away from trade-war hit China.

Source: KPMG, Credit Swisse, DreamLadder Capital Research
Source: KPMG, Deloitte, DreamLadder Capital Research

Fiscal Deficit to rise; negative for bonds but positive for the currency

The government has estimated revenue loss of Rs.1.45 trillion i.e. 0.7% of GDP for FY20. Fiscal Deficit is a function of (expenditure – revenue) in the numerator and nominal GDP in the denominator. As only 58% of the revenue forgone (Rs.1.45 tn) will hit the central government P&L (another 42% goes to the states), the impact on Union Fiscal Deficit through numerator would be much lower than the general perception in the market. Similarly, an uptick in the economic activity will increase the denominator and hence lower the percentage.

A higher Fiscal Deficit (lower than 70bps, as per the media reports) implies greater supply of government paper and hence negative for the bond market. As expected 10 Yr G-Sec spiked 17bps to 6.81% on Friday, after this big announcement. As the Interest rate is a function of 4 variables – inflation, real repo rate (Repo rate minus Inflation), term premium (10 Yr G-Sec minus Repo) and credit spread, the actual movement would depend on the dynamics of these 4 factors. Except for inflation, other variables are still at the higher end of past ranges. Hence, any mean reversion in these other 3 factors, can translate into a downward movement of the interest rate.

On the other hand, this move is likely to be positive for the currency on the back of potential reversal of recent capital outflows.

Source: Credit Swiss Research, DreamLadder Capital Research

Sectoral Impact – Who Benefits??

We assume that corporate would keep bulk of the tax cut, while only a part would-be passed on to the end consumers in terms of lower prices. As per the consensus estimates, Automobiles, Banks, Capital goods, Consumer staples, Diversified financials and Oil, gas & consumable fuels will be key beneficiaries of this sharp cut in corporate tax rate while Electric utilities, IT and Pharmaceuticals will see little or no impact.

Banks would be the biggest beneficiaries with 10-12% earnings impact. However, the current year earnings impact would be lower for banks, given the impact of deferred tax assets. In the FMCG sector, companies like Asian Paints, Britannia, Colgate, HUL would see a positive impact of 11-14% on their earnings. In the auto sector, Escorts & Hero Motors would see the benefits to the tune of 12-13% while other OEMs like Maruti, M&M, Tata Motors & Bajaj Auto would see 7-8% kind of earnings impact. Similarly, in the Pharma sector, Domestic MNC players and few API CRAMs companies would-be beneficiaries to the tune of 11-12 in terms of earnings while export-oriented pharma companies would see a limited impact.

Source: Credit Swiss Research, DreamLadder Capital Research

Earnings upgrade for Nifty/Sensex; positive from the equity market perspective

The corporate tax cut is likely to give a huge boost to private Capex particularly the domestic manufacturing sector. India is also well placed to benefit from the manufacturing shift away from trade-war hit china. 

As per the consensus estimates, earnings of the Nifty50 Index is likely to grow at 25% during FY20 versus earlier expectations of 15-16% on back the sharp cut in the corporate tax rate. As Nifty 50 is trading at 19.2x FY20E and 16.1x FY21E (consensus earnings) which are reasonable, especially given the low-interest rates. We recommend our clients to follow portfolio approach and buy good quality Mutual Funds, in line with his/her risk appetite.

Source: Bloomberg, Kotak MF, DreamLadder Capital Research

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