Tax SOPs as an Instrument to Kick-start the Innovation Cycle
Taxation regime and incentives often define the relationship the global business community will have with a country. Governments, be it federal or state or even city administration, view tax cuts and tax sops as a potent weapon in their arsenal to lure businesses in their respective country or state or city. But are the leaders in the executive branch using this instrument as a strategic lever to foster long-term growth or are they just pandering to the cheap populism and using it as optics booster and short-term gains? In most of the cases of tax sops, it is the second case.
In this piece, I am going to try to outline a framework how administrators can review their decisions to provide tax cuts under a strategic lens and choose the correct businesses to pony up to. The first thing the elected representatives must understand that like a corporation has a finite investment pool to invest in new projects in any given year, the country finances can also afford to dole out tax sops to specific entities only to maintain fiscal prudence and prevent budgetary slippages. So, backing the right horse is a necessary step.
Now let us look at it from the point of view of the stakeholders. First, why would the businesses need tax sops? Well, tax outgo is one of the biggest line item in the P&L statements of the corporations. A tax sop in most cases has a much bigger impact on the bottom line than a multitude of cost reduction projects. The effort to benefit ratio is just too high for the big businesses to ignore tax sops. But that is what they want. The question is, do they really need it?
I think the businesses who truly need tax sops are the ones who are in the innovation phase of their industry life-cycle. I will give the example of battery manufacturing for electric vehicles here. Not only is the technology at a nascent and development stage, electric vehicles are still not mainstream and hence the corresponding battery manufacturing industry has not achieved the benefits of economies of scale yet. The cost curve of this industry is right now at the far left. So, to make this industry competitive and sustainable in comparison to the entrenched incumbents (the fuel guzzlers), tax sops are necessary. I would go as far to say impose an environmental cess on the traditional vehicle manufacturers to penalize them to make the EV industry more competitive. In economics and sustainability parlance, such incentivization is beneficial to the ecosystem as it aims to replace a bad goods (from the ecological perspective) with a good goods. A perfect example of tax sops to kick-start the innovation cycle and having positive spillover effects from an ecological and societal standpoint.
Now let’s look at it from the other end of the spectrum. What is the motivation behind the elected representatives to offer tax sops?
- Long-term growth incentives:
- Generate employment for the citizens
- Improve quality of life of citizens
- Industry setup is not portable
- Pave way for allied industries to come in
- Short-term gain incentives:
- Create a business-friendly perception
- Optics boost
If all five of these conditions are met, the decision is pretty straightforward. But often there is a tradeoff between the first four conditions and last two conditions. A good leader should always prioritize long-term growth over short-term gain. But alas we do not live in a utopian world. So, it is up to us, the electorate, to scrutiny the decisions of our elected leaders and push them to prioritize long-term growth over short-term gain.
So, what are the three key things the administrators should consider before approving a tax sop for a business proposal?
1. Evaluate the stage of innovation the corresponding industry is at and review the cost curve trajectory for future. Prioritize any industry where unit economics curve has not reached the saturation level yet over the ones where economies of scale have already been reached by the industry leaders
2. Evaluate the position of the industry in the value chain and review if the adjacent industries will also bring in their manufacturing investments to co-locate in order to gain intra-value chain cost reduction benefits
3. Evaluate the ecological impact of the business from both manufacturing and product usage standpoint. Prioritize industries which bring in long-term environmental benefits