The emerging fiscal constrictor knot & tightening logjam for market

But this fiscal path has engendered discernible flips; both inter and intra within the corporate and household sectors.

These flips are manifesting in the following:

• The absolute and its incidence have shifted from corporates to households. But contrastingly, household incomes have slowed considerably, or contracted in real terms at the broader level, while have zoomed exponentially.
• Total burden of taxes on households, including the sum of indirect tax and personal income tax has risen sharply to 74% of gross tax collection of GoI (Rs 28.9 lakh crore Apr-Feb FY24), vs 66% in FY13. Importantly, personal income tax now exceeds corporate profit tax collection (FY24).
• Since, has simultaneously decelerated to a multi-decade low, taxes on households have risen to 16% of their incomes, a 40-year high.
• Household income has decelerated to 8.5% FY24E (5-year CAGR, or 2.8% in real terms) from a high of 16% in FY13.
• Contrastingly, the incidence of taxes on corporations has fallen to a multi-decadal low of 22.1% (corporate tax/pre-tax profits) despite the surge in profits in the past pandemic era.
• Corporate profits as a percentage of sales have increased to 11.5% in FY24, rising from FY19 lows of 4.4%; it now exceeds the previous peak of 10.3% in FY08. Consequently, Corporate tax incidence has fallen from 40.8% in FY19 to 22.1% in FY24.
• Therefore, the corporate tax cuts in 2019 coupled with increasing market power and global bounties led to a flip of corporate tax incidence falling to a two-decade low and the profit-to-sales ratio rising to multi-decadal highs.

Thus, households face a double whammy of decelerating real income and peak tax incidence. This co-exists with peak corporate profitability engendered by rising monopolistic power, and lower tax incidence thereby leading to increased . This duality reflects the heightening dichotomy between the booming markets and languid household situation on the one hand and the enlarged deviation between the headline real GVA and core growth on the other.

What constitutes the constrictor knot?

• Notwithstanding all the above maneuvering, the core real GDP growth stands at 3.2% (GDP ex discrepancies) against the headline growth of 8.2% (1Q-3QFY24), global trade has slackened, and private capex is still elusive. The household demand situation remains frail because of subdued real income, and negative fiscal multiplier.
• The envisioned crowding in effect on private capex has not materialized despite the continued supply-side stimulus over the past 7-8 years and government infra capex funded by enlarged tax incidence on households.
• The for GoI’s has tightened as the scope for sustaining lower to states is diminishing. Over five years of FY21-FY25BE, the share of gross tax devolution has been skewed in favour of the centre with the states getting only 32%, significantly lower than the 41% specified by the 15th Finance Commission. The reason why GoI had to rely on non-tax revenues like the outsized dividend from RBI is the higher share of tax devolution to states in FY24 at 35.8% (Apr-Feb).
• The deceleration of nominal GDP has also decelerated to 9% in FY24 from 16.5% average in FY22-FY23 and 12% pre-covid average implying that growth in tax collection could also slow.

Thus, fiscal space has dwindled as a) the tax burden on households cannot be increased further, b) corporate profits are at the peak, c) tax devolution to states from the divisible pool is rising, and d) gouging into ’s balance sheet may not be a recurrent option.

Policy options with the government:

• Expand fiscal deficit by increasing their expenditure, particularly in rural or to support household income. This will catalyze domestic demand.
• The GoI may also accelerate the pace of asset monetization, like PSU divestments, and increase reliance on the balance sheets of PSU companies.
• If the fiscal prudence path is sustained, tax revenue constraints will call for reduced spending. If they reduce revenue expenditure, it will further accentuate the negative multiplier effect on rural demand. However, if they choose to reduce the capex, then the market impulses could be adverse as it has been the largest contributor to the enlarged market capitalization in recent times.
• The tricky part would be to rebalance the elevated tax burden on the households to the corporates. If the corporate tax rates are increased, it will impact the corporate earnings growth and market valuations at a broader level.
• In case the government maintains the status quo, the household situation will continue to remain languid, as in the absence of further fiscal commitments profit growth of companies will eventually converge to low core growth.

Thus, the fiscal situation appears to be stuck in a catch-22 logjam. The choice is between the path of fiscal prudence in the realms of weakening demand thereby accentuating the deceleration and accepting a larger fiscal deficit as the lone demand driver.

A potential escape route from the tightening constrictor knot could be a strengthening in private capex and meaningful gains in employment and household incomes along with improvement in global demand.

ETMarkets.com

ETMarkets.com

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