Fears of a backlash

President Barack Obama proposing the tax reforms in his speech at the White House on May 4. Beside him is Treasury Secretary Timothy Geithner.-RON EDMONDS/AP

BARACK OBAMA has unsettled Indias information technology (IT) barons. In a statement phrased for effect, the United States President told U.S. companies that he proposed to revise tax laws that allowed 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 caused consternation in India, with the media speculating on its implications for the IT and IT-enabled services (ITeS) industries.

The cause for concern is obvious. Exports account for an overwhelming 66 per cent of revenues in Indias much-celebrated and pampered IT and business process outsourcing (BPO) industries. Of these exports, NASSCOM (National Association of Software and Services Companies) figures suggest that the U.S. accounted for 60 per cent of the revenues in financial year 2008 (followed by the United Kingdom, with just 19 per cent). This concentrated export success is substantially due to the industrys 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 industrys largest market and reverse its success in the past decade and a half.

However, the tax reform measures currently being proposed by the Obama administration are not directed at eroding wage advantages or blocking outsourcing. Obamas reference was to a deduction for American companies when they invest in subsidiaries outside the U.S. As a statement from the U.S. Treasury makes clear, currently 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. Yet, they can avail themselves 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 that invest overseas relative to those that invest and create jobs at home.

The difference can be substantial. A company investing in the U.S. 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 would only have to pay a 10 per cent tax on profits from such investment until such time as it brings those profits back and shows it in the revenues of the parent firm. The proposed reform would change the rules on 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 will take effect in 2011, will 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 by 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 U.S. companies are significant. And investments in India and China epitomise the shift overseas in order to reduce costs. According to reports (Business Line, May 7), the top five or six U.S. IT services firms employ over 2.5 lakh professionals in India, with estimates of employment in India in subsidiaries of General Electric, IBM 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 U.S. companies that invest in India will 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 firm, 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 ITeS sectors, these companies stand to benefit from the prevailing U.S. tax law. When the proposed changes take effect, they will lose that benefit, and Indias competitive edge as a low-cost location will be partly undermined. But, as has been noted by many, the competitive edge that comes from Indias lower wage rates is so large that the loss of the tax advantage should not deter captive outsourcing.

The second set of companies that will be affected comprises U.S. companies that 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 until recently. If and when the current slowdown bottoms out and the recovery begins, the profits earned by these companies from the Indian market will be substantial.

Hence, these companies are unlikely to walk away from the Indian market just because they will 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 an imbalance: 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 Indias hardware industry is unlikely to result from Obamas call to end tax discrimination in favour of investment overseas.

If the new measures are more a threat to the profits earned by U.S. companies than to the phenomenon of outsourcing itself, what accounts for the sense of unease that pervades the Indian industrys and medias 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 Indias 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 U.S., 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 fallout of the recession that the Obama declaration highlights also brings to the fore the industrys vulnerability, which has always been swept under the carpet. That vulnerability stems from the dependence of Indias IT success on software and services, on exports, and on principally one single overseas market. It was ignored when times were good but has to be reckoned with today.

Finally, Obamas moves challenge an aspect of policy that the IT and IT services industries in India have substantially benefited from: tax concessions that discriminate in favour of one set of players. The corporate tax concessions that 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.

Obamas actions question whether such concessions, which discriminate in favour of one set of capitalists, is good policy. That is a larger question that Indias IT barons would prefer not to face in todays environment, if ever at all.