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Offer a tax break for not laying off
February, 05th 2009

What is rational for individual enterprises could spell gross irrationality at the level of the economy. Job cuts at a large number of companies, in the wake of the slowdown, is a good example of this phenomenon. As individual companies try to cut costs and reduce the impact on their bottom lines by laying off workers, the cumulative result is to depress demand for what all companies produce in the aggregate. This accelerates the slowdown, and releases further pressure to cut costs. There must be intervention at the macro level to stop this vicious cycle.

The government has already announced two fiscal stimulus packages to boost demand. In addition, it might be a good idea to offer a purely temporary tax break for companies that do not lay off staff.

When a company lays off staff, the effect is not felt just on those laid off. The fear of further downsizing haunts the staff who remain on the rolls and dampens their enthusiasm for sizeable expenditure of any kind. Any plan to buy a home, replace a TV set or purchase a new car gets postponed. A whole lot of additional discretionary expenditure gets cut.

All of this hits demand in the economy. The laid off employees might default on repayment of home loans, mortgages might get forfeited and home prices could stay depressed or, worse, suffer expectations of further decline, triggering postponement of any decision to purchase, on the part of buyers, or build, on the part of builders. All this makes the slowdown worse.

For many companies, lay-offs are a defensive reflex action on the part of the management. Other companies in the same industry are laying off people. So if you dont follow suit, your shareholders are likely to ask troubling questions.

So the axe falls. If there is an incentive that would justify not giving in to this reflex, many companies would refrain from lay-offs. Such
incentive could take the form of tax deferment, which would protect current cash flows, or a tax credit linked to the companys wage bill. The credit could carry over to whenever the company starts paying tax, for example in the software industry where companies pay little tax at present thanks to tax breaks on exports.

There are many sound reasons for companies to lay off people. Boom times tend to encourage liberal hiring. Staffing gets bloated. Lean times provide the occasion to trim fat, get rid of non-performers and raise productivity. And save on costs, too, in the process. This makes for perfect rationality at the level of the individual company. But at the level of aggregate demand in the economy, individually rational decisions add up to an irrational blow to growth and investment.

The current crisis is no ordinary economic problem. It is a globally synchronised decline in economic activity, pushing all the major economies into outright recession and slamming the brakes down on growth in emerging economies such as China and India. And it comes on the back of a financial crisis that has left lenders without any appetite to lend. These extraordinary times call for extraordinary steps, clearly demarcated as temporary measures that would be discarded once growth revives.

India is in a position to insulate itself from the global crisis to a much larger extent than the trade-dependent Asian tigers. Exports, in absolute terms, amount to nearly a quarter of the total output, true, but wages and salaries and gross profits generated from exports account for less than a tenth of the total income. So the economy can withstand sharp slowdown in export demand, and reap the benefit of cheaper imported inputs to feed domestic growth. The key trigger would, of course, be stepped up public expenditure, particularly in infrastructure, to generate demand and utilise industrial capacity.

Of course, tax breaks and additional expenditure would jack up the fiscal deficit in the short run. This is wholly desirable. The point is to bring it down when the cycle turns.

Income tax changes need legislative sanction. The current proximity to elections would, in the normal course, forestall such changes till after the elections. These are not normal times, however. The economy cannot afford to wait for six crucial months for the next full budget to make the needed tax changes. Conventional notions of budget-making propriety need to be set aside. It is possible for the government to seek non-partisan support for a tax break for companies to halt avoidable lay-offs, and for the Opposition to accommodate such a request.

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