Incidence of indirect tax cuts

The finance minister announced in the recent budget the reduction of Central Value Added Tax (Cenvat) on all goods from 16% to 14%, in an effort to spur consumption of manufactured goods and provide a filip to the industrial sector. The excise duties on small cars, two-wheelers, passenger three-wheelers, and buses have been reduced from 16% to 12%. Similarly excise duties on all drugs and some diagnostic and surgical items has been lowered from 16% to 8%. On some categories of packaged food items, the rates have fallen from 16% to 8%. Full excise duty expemptions have been given to the anti-AIDS drug Atazanavir, specified refrigeraration equipments for cold storages, and some IT equipments like the wireless data modem cards.

It is claimed that these indirect tax cuts will boost a flagging manufacturing sector and also contain inflationary pressures. Both these claims do not stand the test of close scrutiny. While the manufacturing sector has been slowing down, it is far from being a precipitous decline that merits Government intervention. It has become a standard practice for the corporate world to call for government intervention at the slightest trouble in the markets, while excoriating government and its regulations at other times.

The time has now come for Indian industry to stop relying on government intervention to remedy cyclical demand fluctuations, except in recessionary and other exceptional circumstances. Firms should re-engineer themselves to be flexible enough to adapt to short term market movements. The inflation control logic too stands on weak grounds. The cuts are too small to make any appreciable anti-inflationary impact, and in any case, the income tax cuts and the Sixth Pay Commission largesse will easily overwhelm any inflationary controls that the lower duties will generate.

I am not sure whether there have been adequate analysis of who gains from these tax cuts. I have not come across studies indicating how the reduced taxes get shared between the consumers and the producers. What are the price elasticities of demand for these goods for which duties have been lowered? Is it likely to increase consumer demand? Is it necessary to resort to fiscal tinkering every time demand shows signs of slackening?

Consumer durables (both the basic and the differentiated niche products) in a fast developing and expanding market like India has been shown to exhibit more inelastic than elastic characteristics on the demand side. This will ensure that the incidence of any tax will be more on the consumer and the major share of the benefits from any tax cut will accrue to the manufacturers. In fact a few cases like the Tata Nano car, such excise duty cuts could end up as an effective backdoor subsidy to the manufacturer.

Excise duty cuts on drugs and other pharmaceutical products will lower the prices for many goods, but again being inelastic goods, these cuts are likely to benefit the pharma companies more than the patients. The demand for packaged food items too is likely to be inelastic for the small tax cuts proposed. Demand for motor vehicles and automobiles is likely to rise and the lower taxes are likely to benefit the consumers too. But here too the incidence will vary and confer significant tax credits to the automobile manufacturers.

Given that the Finance Minister had already rejected all claims to lower corporate tax, saying that the private sector is doing well and does not need any assistance, it would seem that this indirect tax cut largesse is mis-directed. It transfers a disproportionate share of the reduction in taxes to the manufacturers. This intervention by the Government is therefore more a case of tax cuts increasing the bottom lines of the manufacturers, than lowering the prices and transferring money back to the consumers. The later is only incidental. There are other ways in which benefits can be transferred more directly and exclusively to the consumers, thereby effectively lowering prices and boosting demand without mis-directing the transfers. More about this in another post.

However, in so far as all taxes are distortionary and causes inefficient allocation of resources, any reduction in taxes reduces deadweight losses and increases efficiency. To that extent, these duty cuts are unambiguously good.

Update 1
Benefits for the corporate sector in Budget 2008-09: CENVAT brought down by 2%, CST by 1%, 4% cut in excise duty for small automobiles, and 2% cut in excise duty for other manufacturing comapnies, some MNC pharma companies to bebefit from 8% cut in CENVAT.

Update 2
It is now emerging that the consumer goods manufacturers may not pass on any of the excise duty cuts to the consumers. Manufacturers may use the tax cuts to cover for the rising input prices. If this is true then the duty cuts are an effective subsidy to manufacturers.

Update 3
The drug makers too seem to be averse to passing on the duty cuts to patients, understandable given the extremely inelastic nature of drugs, especially basic drugs. The drug price regulator National Pharmaceutical Pricing Authority (NPPA) has had to step in to mandate the passing on of the duty cuts to consumers.