The celebrated economist Milton Friedman once famously remarked, “The nineteenth century … a period when … the spending of the federal government, in Washington, amounted to less than 3% of the national income, … let me point out that, that was also the period of the greatest flowering of charitable activity in the United States.” Given that we are one of the very few countries that mandate firms to spend on corporate social responsibility-related activities, understanding the relationship between corporate taxes and CSR spending is important in the Indian context. I find a negative relationship between CSR and tax payments in the data. The corporate social responsibility mandate reduced tax compliance, whereas the 2019 corporate tax cut increased CSR spending.
Section 135 of the Companies Act of 2013 requires the qualifying firms to spend at least 2% of their average three-year after-tax profits on CSR-related activities. The qualification criteria are based on the level of sales, net worth and profits. Firms that breach any one of the specified thresholds are required to spend at least 2% of their profits on CSR-related activities. Even if beneficial to the broader society, direct business expenditure is not counted as CSR. A failure to comply requires an explanation from the board. The law does not clearly define what can be considered a reasonable explanation for non-compliance. Several show-cause notices have been issued to alleged non-compliant firms. Expectedly, several business executives have expressed reservations about mandating CSR spending, and NGOs, by and large, welcome the law.
In a recent working paper, I compare the tax payment of firms that qualify into the law by a small margin and those that miss qualification by a narrow margin. Suppose the threshold is `500 crore in net worth. In that case, I compare firms with a net worth of `499 crore and those with `501 crore. The advantage of this design is that these firms are otherwise similar and are only separated by a threshold imposed by law. I find that firms that are forced to spend on CSR reduce tax payments significantly. Most interestingly, the reduction in tax payment is very close to the additional expenditure these firms are forced to incur due to the CSR mandate.
It appears that these firms treat forced CSR as tax. They resort to tax aggression to compensate for the loss and the paper shows why this becomes profitable when the CSR mandate is imposed. In short, tax-aggressive strategies that were not viable at a lower tax rate become feasible when additional CSR is considered a tax and added to it. The research design of comparing otherwise similar firms on both sides of the CSR cut-off ensures that the reduction in tax compliance can be attributed to the mandate.
Next, I ask what happened when the government cut corporate taxes significantly in September 2019. Firms received an option to reduce their effective corporate tax rate to close to 25%. Firms that opted for the lower marginal tax rate could not claim specified deductions. The tax cut was particularly beneficial to firms whose marginal tax rate was upwards of 35%. The cut substantially increased the free cash available in the hands of many firms. What do these firms do with the additional free cash flow?
If Milton Friedman’s observation quoted at the beginning is correct, firms that benefit from the tax cut should see an increase in CSR spending. Using a tight design of comparing similar companies differentially exposed to the tax cut, I find that firms that benefited significantly increased CSR spending. A 1% reduction in the effective tax rate leads to a close to 18% increase. Consider a firm spending `100 on CSR before the tax cut and experiencing a five percentage points reduction in its tax rate. Our results suggest that such a company nearly doubled CSR spending after the tax cut. The increase is over and above the minimum 2% of profits required by the law. Thus, the tax rate seems to have played a significant role in influencing corporate charity, especially during the pandemic’s peak.
These results call for a debate about the current approach of mandating CSR spending in India. In its true spirit, charitable spending is only a part of corporate social responsibility. The scope of CSR is much broader. It includes responsible behaviour towards all stakeholders, including the environment, future generations, employees, residents of regions where a firm is located, the government and others. Thus, redesigning products to reduce the possible health hazards they are likely to cause or designing processes that minimise pollution may be as important as corporate charity. Most of these actions do not come under the purview of corporate social responsibility under the law. The law seems to define CSR narrowly as corporate charity and thus socially responsible actions like improving product design are not considered part of it. It is important to design policies that promote overall social responsibility rather than forcing all firms to spend on charity. The exclusive focus on charity and forcing firms to spend on it seems to have the unintended consequence of turning CSR into a tax.
Prasanna Tantri
Teaches finance at the Indian School of Business
(prasanna_tantri@isb.edu)