Depreciation rates and India Inc’s taxes

If excise and corporate taxes will come down, so must depreciation tax breaks

In an economy where labour is more abundant than capital, it is natural to favour employment-intensive technologies. But India had a pronounced heavy-industry bias in the strategy for industrialisation since the 1960s. This also found its place in the structure of tax incentives.

To incentivise private industry to invest more in capital-intensive methods of production, the government chipped in by offering abundant tax breaks for investment in physical capital. So, in contrast to OECD levels of the depreciation rate at 10 per cent, a rate of 25 per cent was offered in India.

If an entrepreneur or a VC were evaluating two alternative projects — one labour intensive and one capital intensive — a depreciation rate of 25 per cent would generate a bias in favour of capital-intensive project.

The current tax system remains designed to generate a bias. The consequence of this policy, along with other policies related to labour and industry, has been to slow down the rate of employment growth in the organised sector.

The Kelkar Task Force has sought to correct this pro-capital and anti-labour bias in the tax structure by reducing the depreciation rate to 15 per cent. The proposed system offers a grandfathering of investments, so that current factories do not get affected. To offset the impact of lower depreciation, KTF proposes to charge a lower rate of 30 per cent corporate tax on companies.

Industry fears that the reduction in the depreciation rate would increase the tax burden. Calculations suggest that it indeed would, but by only about 1 per cent.

When the corporate tax rate was 36.75 per cent in 2003-04, the average rate of tax actually paid by manufacturing firms was 23.5 per cent.

The bias in favour of capital intensive technology is apparent from the fact that banking and finance companies — which don’t use fixed capital assets - paid a higher average tax rate of 28.1 per cent.

The Kelkar Task Force is proposing a “deal” to India’s manufacturing: the standard excise rate would come down from 16 to 12, the peak corporate tax rate would come down from 37 to 30, but in return, the depreciation rate would go down from 25 to 15. Most Indian industry would be happy to get this deal, particularly in the context of global production where successful Indian companies tend to be the ones that exploit India’s strengths in labour.

Capital-intensive companies will obviously try to cherry-pick by taking the drop in the excise rate, taking the drop in the corporate rate, but trying to block the reduction in depreciation rate.

Not only will this continue the anti-employment bias of industry, it will also mess up KTF’s tax projections. In 1997, P. Chidambaram chose to cut rates but let exemptions stay. Will he take on Indian industry this time around?

Ila Patnaik