We are going to stick our neck out and say that with a steep drop in corporate tax rate from 34.9% to 25.6% (effective) in one fell swoop the government has undone almost all of the damage caused by the demonetization. Just as the negative impact of demonetization has been felt for a long time, the corporate tax rate cut will have long-lasting positive impact that will outweigh some of the short-term negative impacts.
Government has signaled to the world that it does not a follow a socialist ideology nor does it believe in central planning. It has forgone 1.45 lakh crore of tax revenue and instead put that money in the hands of big and small businessmen. The signal here is very clear that the government believes the private businesses are much better at capital allocation. The impact of this 1.45 lakh crore in the hands of private businesses will be bigger than it would have been with the government.
High tax paying companies will now have more capital to either re-invest or return to shareholders. Either way this will give a boost to the economy through a pick-up in private capex, generation of employment and increase in consumption. This is a virtuous cycle that has been missing in India for a long time. The potential increase in per-capita GDP over the next couple of years will get us over the inflection point where the country suddenly starts believing that it is not poor anymore.
The tax rate of 15% for new manufacturing companies makes us extremely competitive. Return on Capital Employed will increase and gestation periods for new projects will significantly reduce. India now has a great opportunity to attract international companies to set up factories in India.
Currency notes in India at Rs 21.71 lakh crore are 22% higher than pre-demonetization. A large part of this is still ‘black-money’. While not a cheap option, we can argue that the lower tax rate, especially 15% for new companies, will act as an inducement for a large part of this to be converted in ‘white-money’. This may be an unintended consequence, but it will help fill some of the gap in government tax revenues. Once this theme starts playing out, suddenly a lot of cash sitting in vaults will become a productive asset. Also, a large part of it will find its way into the banking system and capital markets. This flow has the potential to take the stock markets to new highs.
Interest rates will rise in the short term as the fiscal deficit will be more than earlier budgeted. Government will have to prioritise investment over consumption to reduce the fiscal deficit.
We expect the Nifty earnings to increase by at least 10% with this tax cut. At the average of forward P/E multiple of 18x we continue to expect the Nifty to trade at 12600 in year 2020 an 14300 in year 2021. This leaves significant upside from the current Nifty level of 11300.
Most of our portfolio companies were paying more than 30% tax. They will now have more net income to either reinvest in growth or to pay-out to shareholders. We continue to remain very positive on our portfolio and will continue hold very little cash in the portfolio.