The noise around a weaker tax revenue stream has marred the fiscal profile in the first four months of the financial year 2023-24 (4MFY24) so far, and market chatter is growing on the potential fiscal slippage, especially as the fiscal deficit hit 34% of budget estimate (BE), vs 20% for the same period last year. Notably, 4MFY24 gross tax revenue growth is merely 3% vs 10% FY24BE.
What is striking is the deep contraction in corporate taxes even as corporate sector profits are not stressed. While these market chatters are understood, the wheat needs to be separated from the chaff.
Decoding deep contraction in corporate tax collections
The weak tax revenue stream has been led by 10% contraction in corporate tax collections in 4MFY24 (vs. annual 11% growth in BE). This stands in contrast with the reported 35% profit growth in our 4500 sample of listed/formal corporates in 1QFY24. The deep contraction also puts a heavy load on the rest of the year to catch up. The recency bias has led the market to extrapolate current noise in corporate taxes for the full year. However, we reckon that the corporate tax contraction is more of an anomaly than a trend and this technical/seasonal adjustment by corporates should normalise/smoothen over the year.
Post-Covid stealth reforms & formalisation in direct taxes
Our study hints at a behavioural change seen in corporate tax payment post-Covid, where front-loading/smoothening of advance tax payments has been led by unlisted/SMEs. This possibly explains: (i) a sharp increase in the share of Q1 corporate tax collections as a share of the full year collections for GoI (~20% in FY23 vs <12% in FY19 ~10% between FY01-10), (ii) the increase came despite no extra push by listed companies to front-load their tax payments (they continue to pay ~20-24% of their full-year tax liability in 1Q of each year post-Covid); and (iii) the share of listed firms’ tax payments in Government of India (GoI)’s Q1 Corp tax collections falling to 50% by FY23 vs 70-90% earlier. (See Exhibits 1,2 below)
All of this possibly explains formalization and better tax compliance amid GST-led enhanced tax scrutiny/better estimation of advance tax liabilities for SMIDs, apart from factors like better economic outcomes in early growth cycle.
Increased formalisation may explain improved tax behaviour
The behavioural changes seen in corporate advance tax payments post-pandemic also reflect the formalization of the economy, and improved tax compliance amidst GST-led enhanced tax scrutiny for SMEs, apart from factors such as better economic outcomes in the early growth cycle. Enhanced tax scrutiny made SMEs disclose all dealings (purchases/sales) which would assist tax authorities in computing the correct tax liabilities. This probably led to better estimations of advance tax liabilities by companies, which would otherwise delay payment of advance taxes under the garb of estimating lower profits till year-end actual liabilities are calculated/finalized.
Signs of pre-Covid tax behaviour by SMEs again
Startlingly, we are seeing signs of a reversal to pre-Covid behaviour in Q1FY24 corporate tax payments by unlisted/SMEs firms. The share of listed companies in 1Q corporate tax collections by GoI is back to the highs of 76% (vs 50% last year and a pre-Covid average of ~80%). Thus contraction in GoI’s corporate tax revenue may thus be explained by unlisted/SME firms delaying their tax payments in 1QFY24.
We see this is an anomaly and not a trend, we expect corporate tax collections to pick up in 2HFY24 (as the missing SMEs catch up in line with pre-Covid trends and refunds get adjusted for), albeit still growing at a slower pace than budgeted (7% vs 11%). We are yet to find a convincing answer as to why unlisted firms/SMEs would choose to delay their tax payments again. It could be an early sign that the economy is possibly in a late business cycle, with higher costs of capital and real rates have started to pinch them disproportionately. Thereby, falling revenue and profit estimates for these firms is leading them to again choose to push back most of their advance tax payments, as in the past.
Is the revenue stream still an issue ahead, despite improving sequentially ahead on taxes?
Given the non-linear relationship between economic activity and taxes, the overall tax growth undershoots vs nominal growth is not too surprising in the late cycle (just as it overshot nominal GDP in the early cycle post-Covid). Therefore, there is a downside risk for tax revenue, but not to the extent that the negative growth in direct taxes so far is indicating. Nonetheless, revenue needs to be scrutinized closely, including disinvestment for slippages, which could push the government to tighten its purse strings ahead of the election cycle.
Capex frontloading not a fiscal worry; FY24 gross fiscal deficit/GDP (GFD/GDP) to see risk of 20bps slippage
The capex frontloading by the Centre ahead of the election cycle (52% growth/32% of annual capex achieved) has been complemented well by States this year, as the GoI realizes that the multiplier effect of capex comes with a lag. We expect the public capex cycle to remain intact, but it may incrementally slow in 2HFY24.
That said, we see the risk of 20-30bps slippage in GFD/GDP ratio from 5.9% in BE, led by: (1) nearly 0.3%pts and 0.1%pts slippage in net tax revenues and divestment respectively - partly offset by a bumper RBI dividend, (2) lower nominal GDP growth of 9.4% vs 10.5%BE. However, we do not see any material slippage in expenditure and expect govt. to rejig revenue spending rather than spending more. (See Ex 3)
Growth levers still missing
Thus far, public investment and residential real estate have been leading the capex cycle while other agents are missing. On consumption, the urban upper/mid-strata have been leading the recovery. However, negative fiscal impulse on net, lagged effect of tighter monetary policy, and falling income/consumption growth in the urban sector, may imply rural consumption and private investment will have to step up to sustain growth momentum.
The tepid rural income and consumption will, however, be further hit owing to a disappointing monsoon. Besides, sustained broad private capex cycles will require sustained private consumption trends, which seem to be still missing. All this makes us a bit uncomfortable to expect robust FY24 GDP growth and we continue to see sub-6 % print. However, we recognise factors like sustained buoyancy in services momentum and nimble policy thrust to increase trend growth, ahead of the general elections, could add upside risk to our forecast.
Madhavi Arora
Lead Economist at Emkay Global Institutional Equities desk