Wednesday, April 30, 2008

Tale of two tax concessions

Two major policy decisions yesterday by the Government of India.
1. Export duties on steel products increased, customs duty on pig iron and mild steel scrapped, import duties on skimmed milk powder and butter oil lowered. These came as part of the Government's inflation control measures involving removing supply side constraints. The lowering of import duties is aimed at keeping imports cheaper, while the higher export duties are aimed at discouraging exports.

They achieve their objective when the producers transfer a significant share of the duty cuts to the consumers, thereby lowering the prices. How do we ensure this? Does the market mechanism and its functioning ensure the allocation? Eco 101 teaches us that the incidence of tax between the consumers and producers is determined by the price elasticities of demand and supply.

In the instant case, for say, steel and cement, demand is soaring and given the massive ongoing infrastructure and construction projects and overflowing work orders of major firms, we can safely say that demand is likely to be extremely inelastic to prices. On the supply side, the steel and cement prices are ruling high in the world markets. In an integrated global market, these products will flow to those markets where the prices are highest (some of the committed orders will be willing to pay higehr prices) and which are the largest (which we surely are one). Therefore, we can assume that supply will be more elastic, especially when it comes to large markets like India.

In this context, Eco 101 tells us that any tax cut is most likely to be cornered by the producers, both domestic and external. The Government's objective would therefore fail, and the tax cuts would only add to the producers' bottom-lines, already swelling from the historic high prices. The challenge therefore is to get the producers to transfer a greater share of the tax concessions to the consumers, so that the general price level comes down.

There is recent precedent too on this. The large tax concessions given in this year's budget has all gone into swelling the producer's coffers and has contributed little to lowering prices. The Finance Minister has been talking to steel and cement manufacturers and has threatened action if the producers do not pass on the tax cuts by way of lower prices. Maybe such non-market action is necessary to achieve the objective. But can even this achieve it? Let us evaluate after two or three months!

2. Fiscal concessions to STPIs and EOUs extended by a year till March, 2010, and duty on newsprint lowered to 3%. The concession to the software companies will benefit them to an extent of 5-7% on the effective tax rate. These subsidies to the producers are surprising since software and newspaper industry in India is not facing any crisis other than that arising from competitive pressures while competing in a world economy.

The tax concessions under Section 10A to software companies could have been justified in the initial stages when our software industry was finding its feet. But now after having established themselves as highly competitive world-wide, protection and support by way of tax concessions are no longer required. The only purpose to be served by continuing these concessions is to boost the bottom-lines of software companies. In that case, the same logic will be applicable in March 2010 too - for further extension!

No comments: