Barack
Obama has unsettled India’s IT barons. In a statement
phrased for effect, the US President told US companies
that he proposes to revise tax laws that allow them
to pay less taxes if, according to him, you “create
a job in Bangalore, India, than if you create one in
Buffalo, New York.” The specific way in which the issue
was phrased set off consternation in India, with media
speculation on its implications for the information
technology and IT-enabled services industries.
The cause for concern is obvious. Exports account for
an overwhelming 66 per cent of revenues in India’s much-celebrated
and pampered IT and business process outsourcing industries.
Of these exports, NASSCOM figures suggest that the US
accounted for 60 per cent of revenues in financial year
2008 (followed by UK with just 19 per cent). This concentrated
export success is substantially due to the industry’s
access to a cheap English-speaking workforce. So any
effort to erode the wage cost advantage or prevent outsourcing
through buy-American clauses would damage exports to
the industry’s largest market and reverse its decade-and-a-half-long
success.
The fact of the matter, however, is that the tax reform
measures currently being proposed by the Obama administration
are not directed at eroding wage advantages or blocking
outsourcing. The Obama reference was to a deduction
for American companies when they invest in subsidiaries
outside the United States. As a statement from the US
Treasury makes clear, currently, a company that invests
in America has to pay U.S. taxes on the profits from
that investment as soon as they arise. But if the company
invests overseas through a foreign subsidiary, it does
not have to pay U.S. taxes on its overseas profits until
those profits are brought back to the United States,
if they ever are. Yet they can avail of immediate deductions
on their U.S. tax returns for all of the expenses that
support their overseas investment.
This amounts to providing a tax advantage to companies
who invest overseas relative to those who invest and
create jobs at home. Thus, the Treasury argues, “a company
that invests in America has to pay immediate U.S. taxes
on its profits from that investment. But if the company
invests and creates jobs overseas through a foreign
subsidiary, it does not have to pay U.S. taxes on its
overseas profits until those profits are brought back
to the United States”, if they ever are.
The difference can be substantial. A company investing
in the US can deduct the interest expenses on the debt
it incurs to finance that investment and save the 35
per cent tax it would have otherwise paid on every dollar
of costs so deducted. But as and when it makes a profit
it would have to pay a 35 per cent tax on those profits.
A company investing abroad would also be able to deduct
the interest expense on funds borrowed to finance such
investment. But it will only have to pay a 10 per cent
tax on profits from such investment till such time as
it brings those profits back and shows it in the revenues
of the parent firm. The proposed reform would change
rules surrounding deferral of taxes on overseas profits,
so that companies cannot claim deductions in their U.S.
tax returns to support offshore investments until they
pay taxes on their offshore profits. The Treasury estimates
that this provision, which would take effect in 2011,
would yield as much as $60.1 billion between 2011 and
2019.
In itself this proposal seems completely acceptable
inasmuch as it merely opposes special tax privileges
for companies that choose to invest abroad to increase
profits. But by posing it in terms of jobs at home and
jobs overseas and making a specific reference to Bangalore,
the President clearly aims at getting some political
mileage. The Bangalore reference not merely appeals
to nationalist sentiment, but combines it with an opposition
to concessions to corporate America at the expense of
American labour. This works because the numbers employed
overseas by US companies is significant. And investments
in India and China epitomise the shift overseas in order
to reduce costs. According to reports (Business Line
May 7, 2009), the top five or six US IT services firms
employ over 2.5 lakh professionals in India, with estimates
of employment in India in subsidiaries of General Electric,
I.B.M. and Citigroup, placed at 14,500, 74,000 and 10,000
respectively. These are numbers that are small, even
for one country, but enough to excite emotions at home.
However, only US companies that invest in India would
be affected by the new measures and not all companies
that outsource to India. There are two types of companies
that invest in India. First there are those that have
set up captive facilities in Indian subsidiaries to
undertake software production for the parent, offer
software services to the parent firm, manage customer
care or handle back-office operations. Their intent
is to outsource to a captive plant to reduce costs.
To the extent that such cost savings show up as profits
of the Indian subsidiary which are lightly taxed here
because of the special concessions offered by the Indian
government to the IT and IT-enabled Services (ITeS)
sectors, these companies stand to benefit from the currently
prevailing US tax law. When the proposed changes take
effect, they would lose that benefit and India’s competitive
edge as a low cost location would be partly undermined.
But, as has been noted by many, the competitive edge
which comes from India’s lower wage rates is so large
that the loss of the tax advantage should not deter
captive outsourcing.
The second set of companies that would be affected comprises
of US companies which have set up Indian subsidiaries
to undertake production and/or manage marketing and
distribution for sales in the Indian market. These companies
account for a large share of the Indian market for IT
hardware and packaged software which was growing rapidly
till recently. If and when the current slowdown bottoms
out and the recovery begins, the profits earned by these
companies from the Indian market would be substantial.
Hence, these companies are unlikely to walk away from
the Indian market just because they would have to pay
the same rate of tax on their Indian profits as they
pay on profits earned at home. Their home market has
reached saturation whereas the still nascent Indian
market for hardware and software is bound to grow. In
fact, if these companies do walk out it would serve
India well because it could help correct the imbalance
where Indian firms are successful in the software and
services export market, whereas foreign firms dominate
the domestic hardware and packaged software market.
Unfortunately this revival of India’s hardware industry
is unlikely to result from Obama’s call to end tax discrimination
in favour of investment overseas.
If the new measures are more a threat to the profits
earned by US companies than to the phenomenon of outsourcing
itself, what accounts for the sense of unease that pervades
the Indian industry’s and media’s response to the Obama
declaration? There are three factors that possibly play
a role here. First, the Obama statement could not have
come at a worse time for India’s IT and ITeS industry.
After two decades of rapid growth, in the high two digit
levels, the global recession is expected to reduce growth
to the single digit level. While performance varies
many companies are showing much lower sales and net
profits in recent quarters than a year or two before.
And the years of persistently rising hiring seem to
have ended. With exports, especially to the US, underlying
the earlier boom, the possibility that a recession that
is already hurting may generate a backlash against outsourcing
and exports is disconcerting.
Second, the potential adverse fall-out of the recession
that the Obama declaration highlights also brings to
the fore the vulnerability of the industry that has
always been swept under the carpet. That vulnerability
stems from the dependence of India’s IT success on software
and services, on exports, and on principally one single
overseas market. It was ignored in the good times, but
has to be reckoned with today.
Finally, Obama’s moves challenge an aspect of policy
which the IT and IT services industries in India have
substantially benefited from: tax concessions which
discriminate in favour of one set of players. The corporate
tax concessions which have made the IT and IT services
industries the ones subject to the lowest effective
tax rate have played a major role in sustaining the
profitability and stock market success of these firms
and the wealth status of their principal shareholders.
Obama’s actions question whether such concessions which
discriminate in favour of one set of capitalists is
good policy. That is a larger question that India’s
IT barons would prefer not to face in today’s environment,
if ever at all.
|
