6 AM Pacific

Gimme a break - a tax break

Are there industries in India more profitable than the IT industry? If there is one, it must have an awesome business model. Companies like Infosys make 25% net margins after taxes. At $20B in revenues, the industry is no longer a small industry needing encouragement.

So why does the IT industry not pay corporate income tax? Not just that, under the SEZ act, that tax holiday will now be extended, indefinitely.

In the late 80s, early 90s, the STPI Act was used to incentivize the then fledgling IT industry. It was needed. The Software Technology Parks were needed. The cost of a telecom link to the US was high. Many small companies in the STP could share a telecom link. Custom duties were very high on computer hardware, software and networking equipment which could make IT company uncompetitive. So there was the duty-drawback. Last but not least, there was a 10 year tax holiday on export revenue out of the STP. For all this the companies within the STP had to be 100% export oriented.

So far so good. I might have an issue with the tax holiday, but the incentives were timely and well directed. The industry, led by a few major companies like Infosys, TCS and Wipro grabbed the opportunity. Later their ranks swelled with many other smaller companies. Soon the BPO industry (also called ITES or IT enabled services, I think to justify their need for special treatment) also swung into action.

Fast forward to 2006. We now have a large and still rapidly growing IT and BPO industry entirely focused on offshore services to developed markets. Most of the larger firms are very profitable. The custom duties are way down. Telecom bandwidth is dirt cheap. So why in the world would the industry need more tax breaks?

That it doesn’t is very clear. Not just because of the reasons I give. But because industry leaders like Nandan Nilekani say that they don’t. However, if the SEZ provision is available, it would be irresponsible for them to not secure the best tax status for their shareholders.

The income tax lost to the IT industry, by my calculations came to $1.3 B last year. That would be a pretty significant % of the Indian govt. budget. Why would the Indian govt. run a deficit budget, skimp on investment in infrastructure yet spare the wealthy shareholders in Indian IT companies? One could argue that since deficit financing causes inflation, the government is taking from the common man and giving to the wealthy shareholders of IT companies. It is no wonder that the Finance ministry does not support this loss of revenue.

You could also argue that a tax holiday has no impact in the IT industry. If you make profits, you get the benefit of the tax break. But if you make profits, why do you need the tax break? The IT industry is not a capital intensive industry like say the steel industry, where a certain RoI must be met, beyond just being profitable.

The SEZ Act might make sense for many, especially manufacturing industries. For the IT industry it does not. But, profitable industries have wealthy industrialists. Some of them know how to lobby the government. Then there are the real estate developers, who too stand to gain by getting the right to develop the SEZ parks. They too have deep pockets and political connections.

In 10 years when we need to take a relook at the SEZ act, the IT industry will be even bigger. The industrialists will be wealthier. If I were a betting man, I’d say, this ain’t going away.

Tags: India, IT Services

Green Guilt

Yesterday was Father’s Day. I got a great gift from my wife. A TerraPass.

Since time immemorial, man has paid for his sins, quite literally, by slipping a little something to God. At the temple, the church and the mosque the pundits, priests and mullahs will always make it easy for you to leave a little behind in the collection box, in case it makes you feel better. With TerraPass, I just put something into the collection box of the temple of the future, and I must confess, it does feel better.

In a weaker moment last year, I bought myself a sports car (a BMW 645Ci for those in the know). Its looks, the ride, they awaken the senses. Unfortunately, it gives just 17 miles to the gallon. Energy efficiency and such green thinking happens to matter to us. So my passion for the car was contaminated by this guilt - Greenhouse Gas Guilt. The guilt of adding to the world’s CO2 was gnawing at me well before Mr. Gore’s well reviewed documentary An Inconvenient Truth. But it was still not enough to get me to trade in my car for a Prius.

Enter TerraPass. For $50 per year or so, my car is now ‘carbon neutral’. I pay TeraPass and they in turn invest that money into clean energy projects which are ‘carbon negative’ thus neutralizing my gas-guzzler. TerraPass became my Ganga Jal. Instant moksha.

I think TerraPass is a terrific idea. The company is for-profit and so it keeps a portion of your fees for operational costs and profits, but the rest is invested in projects that may not have happened were it not for TerraPass. I can see carbon-neutrality become a hip thing among businesses too.

While we’re on the subject I’m glad that finally some real marketing minds are working for the Green camp. Till a couple of years back we were calling it Global Warming. Most of the developed world happens to live in temperate climates. If you live in Chicago, Global Warming doesn’t sound all that ominous. I can see some people in Minneapolis not being scared at all of the warm toasty images that Global Warming created. The term then changed to Climate Change (still weak) to now Climate Crisis, which I like the best. Fear and Greed - that’s what makes people move. Mix well and add a little Guilt to taste.

Tags: Business

The Worth of a Job

It’s been a long time since my last post. Perhaps too long. Things have been busy at Gridstone Research, the startup I work for and blogging had to take a back seat for a while.

So to make up for it, here’s a meaty subject. Why do people in different professions get paid what they get paid? It’s an interesting subject and I thought I would find some research on it on the internet, but I couldn’t. There’s a lot of data on what people get paid in different professions, but the question we are trying to answer is why.

Let’s first clarify the question at hand. We are not dealing with executive compensation here, although that is quite an interesting (and topical) subject in of itself. We also know that in any profession the higher you sit in the organization chart the more you get paid (generally). What we want to compare here is compensation in different professions - investment banking or software sales or retail bank front office – taking out the effect of position and years of experience. We will ignore stock option related windfalls, which are anyway becoming rare. And for this piece, we assume that we are comparing professions in the same city, so there is no cost of living impact on wages.

After all the assumptions in the last para, you are still left with a significant variation in compensation both at entry level (out of college or business school) or at any time marker after that. The question is why? What makes some jobs worth large amounts of money while others are so-so?

Here’s my hypothesis. If the person in a job can directly impact the company’s profit in a significant, measurable way that job will get paid more than someone in a job that doesn’t.

That sounds almost like a truism. But let’s examine more closely what it means. An example will make it clearer.

Take the job of a Portfolio Manager (PM) at a Mutual Fund. The PM decides which stocks to buy, hold or sell for the Fund. He almost entirely determines how the Mutual Fund performs. If the Fund performs well, its shareholders make higher returns than other comparable funds. The word spreads and more money pours into the Fund swelling the management fee that the Fund Management firm charges. The average mutual fund in the US had assets of $1.05B and expenses of 1.25% in 2005. A 25% increase in assets increases the firm’s fees by over $3 million which should largely drop to the bottom-line. As you can see, the correlation between the PM’s decisions and the business outcomes are very high. Also, and importantly, there are few if any other things that matter. Unlike in a manufacturing company where many people contribute to the value and quality of the product, the PM might depend upon the recommendations of the Fund’s Analysts who research companies, but he makes his own final decisions. Random events or luck play a minor role, especially if these events impact the benchmark as well.

The PM’s job therefore fits our criteria perfectly. He directly impacts the firm’s profits in a significant, measurable way. Not surprisingly, the Portfolio Manager for a Mutual Fund in the US is a highly paid job. Many of them take home over $ 1 million.

Sales people in most industries that sell to businesses tend to get paid more. What predictions can one make about compensation in the Sales profession using my hypothesis? A Sales professional will be paid more when Gross Profit (or Contribution) per Sales professional is higher (significant impact to profit). A salesman for Boeing should therefore be one of the highest paid salesmen in any industry. Also Revenue Producers will be paid more in the Professional Services industries where the Partner or the Banker is the product himself. The client often knows and trusts the Partner or Banker and will give him the deal because of him and not the company he works for (direct impact). Therefore, Management Consultants, Lawyers and Investment Bankers all get paid oodles of cash.

A school teacher’s job is a tough one. They mold young minds. A good teacher can be a glorious thing for a young student. What can be more important than this job to both individuals and society? Yet school teachers are paid very little in almost every country. I have often struggled with this paradox. Why wouldn’t we pay school teachers more and get the best we can for our children?

Let’s take a school teacher’s job and evaluate it against the criteria in our hypothesis. A school teacher definitely directly impacts the outcomes for particular students. This impact can be undoubtedly significant. You might decide to become a writer because of a superb English teacher, or totally lose interest in Biology because of lousy one. However, a school teacher in the US typically works for a public (government) school and not for a business. And the outcomes for students discussed above are not exactly measurable outcomes. So a school teacher’s job doesn’t fit the criteria in our hypothesis on a couple of counts. So school teacher salaries will predictably be low, attracting average talent and with lower incentives to excel.

On the other hand, consider the teachers in Delhi’s IIT coaching classes. Their outcomes are very measurable – the students’ JEE rank. The students’ JEE rank drives both the enrollment in the coaching classes and the fees per student. No wonder these teachers can take home as much as Rs. 15 lakhs a year, a salary that an ordinary school teacher in India can only dream of.

I think the hypothesis in general works. But like most things in the complex world of business, it’s hard to make rules stick. There are always eddy currents that produce exceptions. If you find any, let me know.

Tags: Economics