We don't need your tax breaks

While the ministry of finance appears to have beaten a retreat on the proposal to begin taxing BPO operations, the business process outsourcing (BPO) industry remains in a tizzy. And has begun making loud protests, citing the usual arguments against the possibility that some day they will be taxed.

One argument, made by Nasscom chief Kiran Karnik (The Times of India, January 7) is that the taxman is benefiting by Rs 2,500 crore through income taxes paid by employees of IT units, and so the same logic should be applied to BPO units — that, by the way, is tantamount to saying Maruti Udyog doesn’t need to pay taxes because its workers pay income tax, and the government gets import duties every time Maruti imports components from abroad.

Others have begun arguing that, if BPO units are taxed, MNCs will move their business to other countries like the Philippines or Mauritius.

The argument may finally win the day, though I think it would be difficult for anyone to justify not taxing such an obviously high-growth area in the years to come.

For one, though the cut in customs and other duties was needed for efficiency reasons, this has resulted in India’s tax-to-GDP ratio falling from 16 per cent in 1990-91 to 14 per cent in 2002-03.

Second, the way things are today, the tax-base is still mostly structured to get manufacturing units into the tax net, but this sector is in relative decline. While attempts have been made to tax the burgeoning service sector, not taxing high-value elements of it have meant service tax contributes under a quarter of one per cent of GDP.

So, I for one, wouldn’t be surprised if BPO and other units, such as exporters, come into the tax net over the next few years, especially as domestic distortions start disappearing and earning of foreign exchange ceases to be as all-important as it is today.

But this will kill the industry even before it is fully-born, I can already hear angry protests, and if the industry moves away from India, how will it generate any taxes?

While everyone’s free to make up their minds, I’d invite your attention to two recent studies, one by the think-tank ICRIER and the other by consultants McKinsey & Co. So, one’s swadeshi and one’s videshi, but both make much the same point — that tax breaks don’t really matter as far as foreign investment is concerned.

Take ICRIER first. A paper by Rashmi Banga studies the impact of various elements on attracting foreign investment in various Asian countries for a period of two decades.

All manner of variables have been chosen to examine whether they have an impact — these include the size of the local market, the availability of infrastructure like electricity, the budget deficit, the rates of interest, education, labour productivity, external debt, import duties, and so on, even fiscal incentives.

Indeed, Banga makes a distinction between the impact of these variables on investments from developed countries and that from developing ones. The results show that while India’s large market size, availability of skilled labour and higher electricity availability are statistically significant factors in attracting FDI, the cost of capital or the budget deficit are not particularly important.

High import duties, interestingly, actually deter FDI. And while removing restrictions (like not allowing FDI in certain sectors, or taxing them at different rates from local industries) has a major impact in attracting FDI, fiscal incentives are not a significant determinant of FDI.

There’s a bit of a caveat here. Fiscal incentives don’t make much of a difference as far as FDI from developed countries are concerned, but they are important, however, for attracting FDI from developing countries (so, Chinese BPO units will shift shop when tax incentives go, US ones won’t!).

The latest McKinsey Quarterly tackles the subject differently, through a survey of 30 executives of companies who’ve moved jobs to India. McKinsey argues that while Indian income tax concessions for IT jobs add up to roughly $ 6,000 annually for each full-time employee in these companies (and $ 2,000 for every call-centre type back-office professional), these are redundant now that India controls more than a fourth of the global market.

Of the five factors listed by the executives for shifting to India, tax incentives were the last. Indeed, most of the executives said they’d rather the government spent the money on upgrading local infrastructure! The size of the domestic market, and the quality of labour force (all factors tested by ICRIER’s model) were cited as more important.

The most ironic part of the study, of course, is the interview with executives of Ford which got huge tax breaks when it set up shop in Tamil Nadu (anywhere between $ 200,00 and $ 400,000 per job created).

The executives said their decision was based on, in order of priority, availability of a supplier base and skilled labour and the quality of infrastructure. “The generous financial incentives”, McKinsey says, “were only as important as proximity to a port. Land subsidies were even less significant.”

At an intuitive level, the reason for this is obvious. Foreign investment is coming to India due to certain intrinsic advantages the country offers, and in most cases that is several times larger than the tax-advantage being sought.

Besides, McKinsey argues in another piece, BPO units in India have a lot more scope to increase efficiencies — if done, that will further negate the need for tax breaks. Running round-the-clock shifts, to cite just one example, would cut costs in BPO operations by 30-40 per cent.

It’s ironic, but in this season of India Shining, Indians continue to have a very poor view of their strengths, and that’s why they think offering tax sops will attract investors.