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Demand side vs. Supply side economics - Debate Resurfaces

Demand side vs. Supply side economics - Debate Resurfaces

  • Date27 Sep 2019
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The Rupee has been spooked by a combination of global and domestic factors. It has depreciated nearly 3.5% in a matter of a few sessions to hit a eight month low. On the domestic front, policy flip flops pertaining to issue of sovereign foreign currency bond and super rich surcharge for FPIs induced uncertainty. It resulted in outflows from domestic equity markets. On the global front, escalation in trade war between US and China dampened risk sentiment and outlook for global growth. This resulted in unwinding of carry trades and flight of capital from riskier EM assets to safe havens such as US treasuries and Gold. The PBoC responded to fresh tariffs by letting the Yuan depreciate. USD/CNY broke the psychological 7 level. The Rupee and other EM currencies have closely tracked the Yuan.

The cut in corporate tax rate by the government reignites the debate as to what is more effective “demand-side” or “supply-side” economic policy.

Putting it simply, proponents of demand side argue that it’s the aggregate demand that drives economic growth and therefore stimulating aggregate demand incentivizes companies to invest and increase capacity. Keynesian economics is classical demand side economics.

Proponents of supply side believe that cutting tax rates incentivizes companies to invest which in turn leads to job creation and which in turn spurs demand. Supply side economists believe in the Laffer curve i.e. reducing tax rates up to a certain point increases tax revenues as overall growth increases. Supply side economics is popularly summed up by the adage that “The tax cuts pay for themselves” and by Say’s law i.e. “Supply Creates its Own Demand”. US president Ronald Reagan extensively used supply side economics, so much so that supply side economics is often referred to as Reaganomics.

In India’s context considering that the growth is stalling and that the monetary policy is on full throttle in attempting to stimulate the economy from the demand side, the corporate tax cut is an attempt to stimulate the economy from the supply side. The government would have weighed its options to revive growth i.e. embarking on a massive spending spree, cutting income taxes, cutting corporate taxes, cutting indirect taxes.

It ultimately chose to fulfill the industry’s long-standing wish of lower corporate taxes. Though it is a welcome move as it aligns India’s corporate tax rate with its peers and makes it competitive on the taxation front, it is just a first step towards minimizing the role of government and incentivizing the private sector to step up investments. Higher corporate taxes were not the only deterrent to private CAPEX.

Much more needs to be done on the governance front to improve the ease of doing business for the private sector. Hopefully, the government will initiate land and labor reforms to complement these tax cuts and remove structural impediments to investments. We need to see a major thrust on infrastructure and logistics. The share of capital expenditure as a percentage of total government expenditure is too low at present and needs to be ramped up. We need to see the government exit inefficient public sector undertakings and therefore large-scale strategic disinvestment is the need of the hour.

One would therefore like to believe that India is on the right side of the Laffer curve and that these tax cuts would have the intended benefit in the long run if they were complemented by structural reforms. One would hope that it is not a quick fix to give a temporary fillip to investment sentiment but a part of a well thought out strategy to ensure that “Minimum Government and Maximum Governance” is not just on paper.

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