Why Indian industry may not be investing

India urges industries to invest amid infrastructure push

The Indian government has been urging industrial houses to invest in capacity expansion and new business development, for a decade. However, it has remained subdued despite prodding by the government, even as capital markets were booming.

Meanwhile, the government has been aggressively investing in infrastructure development.

Recently, Uday Kotak, the veteran banker and statesman, opined that the next generation of business families is more interested in investment management in capital markets than in investing in industry and running and expanding companies.

Is this shift in capital allocation a structural challenge that needs urgent policy intervention?

The core issue: Capital flowing into passive investments

One major reason for the reluctance of industrial houses to invest in new capacity could be the misalignment of tax and incentive policies of the government.

Investing in the stock market, mutual funds, and financial instruments offers higher tax-adjusted returns with lower risk and effort than the tax-adjusted returns by expanding capacity or setting up new businesses.

Several factors contribute to this:

• Higher returns in financial markets: The Indian stock market has among the highest P/E ratios in the world, even after adjusting for forex variations, making investment in the capital market more lucrative than expanding industrial capacity or investing in new business.
• Regulatory burden: Setting up and expanding industries involves bureaucratic delays, environmental clearances, and compliance risks while investing in stocks is straightforward and hassle-free.
• Taxation & incentives favor market investments: Governments design policies to encourage certain economic behaviors, and in many cases, tax structures have evolved to favor financial investments (such as stocks and bonds) over direct business reinvestment in industrial ventures.
  This creates an environment where entrepreneurs and investors find it more profitable to invest in financial markets than setting up or expanding manufacturing or service enterprises. Examples are:
  • Lower Tax Rates on Capital Gains (10%) vs. Tax on Business Income (15-25%).
  • Business reinvestment taxation: Profits reinvested often attract taxation at multiple levels: corporate income tax, dividend distribution tax, and personal income tax, reducing incentives to reinvest in production facilities or expansion.
  • There are many more, I understand; a chartered accountant can explain this better.
• Foreign and domestic institutional investment sucking profits from capital markets: Uday Kotak has pointed out that excessive institutional investment (DIIs and FIIs) is fueling stock value gains thus ballooning investment into the financial market vis a vis investment into industry per se. If some of it is incentivized to come into the industry as equity capital, there will be more industrial growth and a moderated ballooning effect in the financial market.

Since even the middle class has tasted the benefits of investment, evidenced by the growth of SIP (Systematic Investment Plan) schemes, we don’t run the risk of unduly suppressing the stock market; it is on a self-propulsion trajectory.

Required policy interventions for course correction

To address this imbalance and channel more capital into productive industrial expansion, the government should consider the following measures:

1. Differentiate between risk capital and market capital

Offer higher tax benefits for investments in startups, manufacturing, and industrial expansion compared to financial market investments.

Recognize investments in companies until they reach profitability as ‘high-risk capital’ and provide incentives (like tax credits) accordingly.

2. Incentivize founder investments & industrial expansion

• Provide enhanced tax credits (say more than 100%) for high-risk capital invested by founders and early-stage investors.
• Introduce a separate category for “founder-invested equity” that enjoys superior tax treatment over silent partner kind of investors.

3. Tax adjustments to industrial investment over market investments

• Peg tax on business profits at lower levels compared to tax on capital market gains.
• Taxation on passive capital gains up to a certain threshold can be low for the benefit of small investors. Above this level, increase the capital gains tax for the rich, not high enough to discourage investment by HNIs and professional investors in financial markets, but high enough to discourage movement of investment from industry to financial market.
• All this can be done in a ‘gross tax neutral’ way, without losing revenue to the government.

4. Ease bureaucratic & compliance burdens

• Simplify approval processes for industrial expansion and ensure single-window clearance for business investments.
• Reduce compliance hurdles to make starting, expanding, and closing businesses as easy as investing in the stock market.

5. Long-term policy commitment

Uday Kotak’s concerns reflect a broader challenge – the increasing dominance of passive financial investments over real economic growth.

Announce a gradual shift in policy changes for policy predictability and to help the industry understand that the government means to offer long-term benefits of retaining capital in the industry and adding fresh capital.

If capital continues to flow disproportionately into financial markets rather than into productive industries, job creation and long-term economic sustainability will suffer.

By implementing targeted tax and policy measures, the government can rebalance capital allocation, encourage industrial investment, and ensure sustainable economic growth.

The time for action is now. The government must redirect incentives towards industrial expansion to transform India from an equity market-led economy to an industrial powerhouse.

Note:
1. Text in Blue points to additional data on the topic.
2. The views expressed here are those of the author and do not necessarily represent or reflect the views of PGurus.

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