For what is considered India’s IT capital, Bangalore has a bit of a split personality. It was here in 1996 that farmers ransacked the first Kentucky Fried Chicken (KFC) outlet in the country. The protest was actually against Cargill’s GM seeds; KFC was just the most identifiable American icon. It was here again last month that placard-carrying protestors targeted the Bank of America, another unconnected but, again, easily identifiable U.S. symbol. The demonstrators were objecting to U.S. President Barack Obama’s appeal to companies to create jobs in Buffalo (New York) rather than Bangalore, and his proposal to withdraw certain tax concessions for companies that shipped American jobs overseas.

Bangalore was a quiet retirement city before IT firms such as Infosys and Wipro — which have their headquarters there — transformed it. Today, the city is in the fast lane. It has, in the past, been targeted by Westerners who have lost their jobs. The adjective ‘Bangalored’ has entered the lexicon; according to Webster’s New Millennium dictionary, it means “laid off due to outsourcing.”

Some experts disagree, however, that the new tax provisions justify these protests or even make them necessary. “Such protests are unfortunate,” says K. Raman, practice head (telecom, media & technology) of the Tata Strategic Management Group (TSMG). “India has seen success in the IT/BPO (business process outsourcing) sector because of certain economic and demographic factors. The large pool of talented people and the cost advantage has worked in our favor.” S. Sadagopan, director of Bangalore-based International Institute of Information Technology (IIIT), says such protests are in bad taste. Raman Kumar, vice-chairman and CEO of CBaySystems, a healthcare transcription technology and services firm, notes: “This is an emotional and impulsive response. I don’t think that reality is quite as dramatic as these slogans have made it out to be.”

Sanjay Kamlani, co-CEO of legal process outsourcing firm Pangea3, sympathizes with the protesters. “Buffalo, thanks to Obama and his fellow politicians, is still convinced that opportunity lies in the so-called heartland of America protected by artificial barriers at the border known as visas,” he says. “At some point, the American public will realize that opportunity lies not in the heartland, but across the Internet sea in Bangalore where brains are free to do work anywhere in the world they please.”

Tax Policy Reform

The controversy was sparked by a seven-minute speech in which President Obama pointed out that the problem with the tax code is that it offers incentives for outsourcing. According to the President, the tax rules say that “you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York…. That’s why I’m asking Congress to pass some commonsense measures…. These and other reforms will save American taxpayers US$210 billion over the next 10 years.”

The reaction was immediate, especially from corporate America. “A preponderance of American companies will say it is a bad move for the economy,” said David Cote, CEO of US$38 billion Honeywell International, who was in Bangalore to inaugurate a new US$50 million R&D and engineering facility. “Economics is not a zero sum game with a my-gain-is-your-loss approach.” Wrote the Wall Street Journal (WSJ): “This ‘solution’ is antigrowth, job-destroying, protectionist and unlikely to raise the tax revenue.”

What are the implications of the proposals? According to Ganesh Natarajan, vice-chairman and CEO of Zensar Technologies and former chairman of the National Association of Software and Service Companies (Nasscom), “The primary intent is to address the tax rate differentials that exist across the world. If implemented, this would impact America-headquartered companies that have overseas operations. Current law in the U.S. states that any income that is earned outside the U.S. is not taxed until such time as it is brought back into the U.S. The Obama proposal aims to alter that to raise the revenues of the U.S government.”

Ravi Aron, a senior fellow at the Mack Center for Technological Innovation at Wharton, offers a more detailed explanation. “Most of what the proposed legislation has to do with is [the] taxation of income earned abroad by U.S. multinationals and the treatment of ‘deferred income.’ It has tangential — if any — implications for offshoring to countries like India and China.”

Aron believes it is important to make a distinction between outsourcing and offshoring in this analysis. “When a PC manufacturer buys a component — say a hard drive — from a third-party manufacturer, we call it outsourcing. If that third-party manufacturer is located outside the U.S., say in China, we call it offshore outsourcing. When a bank buys a service — such as sell side equity research — from a third party located in India, the bank has outsourced a service to an offshore entity. This will not be impacted by the new taxation policy. Just as the PC manufacturer will treat the purchase of the component as a fully tax-deductible expense, the bank, too, will treat the service as a fully tax deductible expense — whether it is delivered from Buffalo or Bangalore,” he says.

Aron points out that the changes in the taxation policy may have marginal impact on what are called “captive centers” of U.S. firms in offshore locations. “These service delivery centers are fully owned by U.S. firms, and their employees work for U.S. corporations. Under the proposed scheme, there may be some marginal impact on these centers to the extent that the tax rate differences between India and the U.S. are quite low — unlike, say, in Ireland, where the corporate tax rate is as low as 12.5%. So even if the captive centers of these firms attract a slightly higher tax rate than they face in their Indian operations, given the very significant wage disparity, the incremental tax will, at best, have a marginal impact. It will be a small fraction of the wage difference between Asia and the U.S. IBM did not hire its nearly 90,000 workers in India and Accenture its 50,000 or so workers for lower taxes.”

Aron adds that the practice of outsourcing services to a third-party company will not be impacted by these tax laws, because this is essentially the same as “the sourcing of components by manufacturers. Isolating a country for special trade-related tax provisions, or isolating services for trade-related tax provisions, will most likely not withstand a challenge at the WTO. This is not the intent of the proposed legislation.”

In fact, the proposed tax legislation has had an interesting side effect, Aron says. “It has inserted considerable uncertainty into companies’ offshore sourcing plans. Many firms are considering — or already planning — to sell their captive centers to offshore BPO and ITO firms. I have noticed as a part of my research that in many kinds of white collar work, when firms offshore services, they tend to offshore them more rapidly to third parties than to their own captive centers. Secondly, when firms sell their captive centers to third parties, sometimes they also offshore related services to that third-party that were being done onshore. This allows them to write SLAs (service level agreements) that are more comprehensive in their scope. It also allows firms to manage these resulting outsourcing relationships more closely. It would be ironic, therefore, if the proposed legislation helps speed up the flight of white-collar work from Buffalo to Bangalore.”

Marginal Impact on Indian Firms

Many experts interviewed by India Knowledge at Wharton believe the new rules will have limited impact on Indian companies. Sadagopan of IIIT says that it may actually help them by making them more competitive. “While American companies will have a disadvantage in this model, I don’t see any huge impact for Indian companies,” adds Scott Staples, the U.S.-based president and CEO (knowledge services) of IT consultancy MindTree. “Business as usual will continue even under the new legislation.” Adds Kamlani of Pangea3: “The new tax proposals benefit Indian IT/BPO companies at the expense of U.S.-based companies that do business in India. This is good news for the Indian IT/BPO industry.”

Everyone is talking about IT, because that’s the image that Bangalore conjures up. But the impact is much wider. “The bill is expected to particularly hit American pharmaceutical, technology, financial and consumer goods companies,” says K.R. Lakshminarayana, chief strategy officer of Wipro. “The bill might not affect the Indian subsidiaries of IT companies as they are already paying a tax which is almost equal to U.S. tax rates. Therefore, Indian subsidiaries will not have to shell out more money in the form of taxes.”

Opinions on the impact of the tax proposals vary widely. “The tax proposals are at a very elementary stage and little is known about their nature and objectives,” says Kumar of CBaySystems. “Until one is able to shed some light on this, their implications cannot be studied.” Adds Amitava Roy, president of Symphony Services, a leading player in outsourced product development: “Right now, there is some talk and a proposal but there is no clarity and no certainty if it will actually pass through. The jury is still out and it is too early to say what the impact will be on either the American firms or the Indian ones.”

Whatever happens, the industry dynamics are unlikely to change, says Ravi Bapna, associate professor of information systems at the Carlson School of Management and executive director of CITNE at the Hyderabad-based Indian School of Business (ISB). “I think there is now healthy competition between the MNCs and the Indian-origin IT services firms,” he says. “Nothing that is there in the proposals is likely to change the structural nature of this competition. Both sets of entities bring different value propositions to the table, and the global market for IT and BPO services is large enough to accommodate the current major players.”

A back-of-the-envelope calculation shows that even if the tax proposals have the maximum impact on U.S. companies, it still makes sense for them to continue with their Indian operations. According to analysts, a service that costs around US$48 per seat per hour in the U.S. is available for US$11-$12 in India. This is for basic-level work; the difference is higher for more sophisticated services. Even if taxes were to increase, outsourcing to India would cost less than doing such work in the U.S.

Strategic Rationale

Besides, costs represent just one of several factors that have prompted U.S. firms to set up operations in India. “Companies that move work offshore do so for strategic reasons that range from cost cutting to gaining capabilities and capacity on demand,” says Bapna of ISB. “When one thinks of long-term drivers of offshoring, such as the aging population and cumulative demographic-skills distribution of the West, the Indian IT and BPO companies have sustainable growth opportunities. A recent Time magazine article points to millions of open job positions in the U.S. in areas such as accounting and bankruptcy and restructuring law. But the recently unemployed (in the U.S.) don’t have the necessary skill sets to fill in these positions. So both unemployment and open positions are rising.”

Meanwhile, the outsourcing business appears to be shrinking, though this could be a temporary phenomenon. According to Market Vista: Q1 2009, a report on global outsourcing and offshoring activity by the Everest Research Institute, an independent research and analysis organization covering the IT and BPO sectors, the global outsourcing market decreased 7% in transaction volume, and the annual contract value dropped 16%, from US$3.55 billion to US$2.97 billion, in the first quarter of calendar 2009, compared to the corresponding period of 2008. The one bright spot was the banking, financial services and insurance (BFSI) segment, which showed a 30% growth.

BFSI accounts for a good chunk of the Indian IT sector’s revenues. Nasscom, which classifies BFSI along with high-tech/telecom, says that these two verticals accounted for 61% of Indian services exports in 2008. The boom in this vertical should be good news for Indian companies. But there are some chill winds.

An April 2009 report by PricewaterhouseCoopers (PwC), a global professional services firm, says that jobs may be moving back to the U.S. for a variety of reasons. The report, titled “Boston, Bangalore, Beijing, Budapest, or Buffalo: The United States as a Low-cost Location and the Implications for Financial Institutions,” says: “With the U.S. government now the single biggest stakeholder in the financial services industry, there is increased public scrutiny on firms. This scrutiny, combined with recent large workforce reductions, may make it politically untenable for firms to engage in significant offshore sourcing initiatives despite their benefits.

“Overall the economy lost several million jobs in the past 12 months, most of them white collar positions. This has created a surplus of talent, available at competitive salary and benefit levels, for companies to draw upon for sourcing. Additionally, state and local governments are actively promoting existing incentives and subsidies; local governments have been aggressive in creating innovative packages tailored for individual transactions, as evidenced by recent transactions in Alabama and Iowa. These factors, coupled with the advantages of proximity, cultural similarity, and risk mitigation, make U.S. and nearshore locations significantly more attractive than at any other point in history. While leading financial services firms have long had shared service centers in locations such as Baltimore, Buffalo, Jacksonville, and Tampa, we are likely to see the emergence of additional locations with significant potential for supporting the financial services sector.”

In India, however, observers see it as a temporary development; when the recession runs its course, it will be business as usual. “I believe that outsourcing is a commercial reality that cannot be ignored,” says Kumar of CBaySystems. “India has an intrinsic advantage to offer.”

The newfound protectionism and anti-globalization are also considered equally short term. “America’s economy and America has always been about pushing onwards and pushing outwards,” says Staples of MindTree. “As soon as you start looking inwards and taking things back inside, you run the large risk of slowing things down.” Adds Roy of Symphony: “Obama’s proposal is contrary to America’s stand on globalization and we don’t really believe that he will force the issue beyond a certain point. The U.S. is far too entrenched in the free market economy, and ultimately the free market economy has to survive. My belief is that outsourcing is going to continue for the simple reason that America does not have the required talent pool.”

“Nations and companies are going to do what is in their self interest, and if offshore outsourcing remains an attractive business proposition, I can’t imagine any U.S. government putting [up] barriers to this,” says Bapna of ISB. Adds Lakshminarayana of Wipro: “We are currently witnessing the greatest challenge to the global economy in modern times. With job losses on the increase across the world, there is bound to be a lot of noise on protectionism. However, the good news is that there was a broad consensus [in] the G-20 summit on avoiding trade protectionism and qualitative restrictions. Globalization is here to stay, and we believe that the noise will settle down and rational thinking will prevail.”

Kamlani of Pangea3 offers a different perspective. “The irony is that protectionist policies are likely to harm Americans much more,” he says. “The immigration restrictions force Indian entrepreneurs and professionals out of the U.S. to India where they establish more offshoring businesses, and the tax policies make the U.S.-based companies less competitive compared to the India-based companies. Thus, more dollars flow to the Indian companies. It all adds up to fewer jobs for Americans. The best way to protect American jobs is to eliminate the trade barriers and the immigration barriers.”

Even as everyone is discussing the U.S. tax proposals, there is a consensus that Indian IT should use this opportunity to put its house in order. Says Staples of MindTree: “The big challenge for Indian IT and BPO companies — irrespective of this or any other legislation — has always been and continues to be to become more consultative to their customers. For this they have to increase their domain knowledge. Indian companies have come a long way in adding the domain story to their technology story but they have not come far enough. Over the next couple of years, they need to take the extra step in terms of becoming domain experts in the industries that they are selling into.” Sadagopan of IIIT has a succinct prescription: “Hard work, higher productivity, talk less and deliver more value.”

“The current crisis has made all firms go through serious introspection,” says Raman of TSMG. “They are all taking a hard look at their own operations and, in the process, also looking at whether their outsourcing decisions — which were taken earlier in a different context — are delivering the expected results and what more needs to be done. One of the key things that Indian IT vendors need to do is get close to their customers and pick up these signals.”

Bapna of ISB believes there are issues beyond IT. “We need serious education reform within India that increases the supply of employable youth, and encourages research and knowledge creation so that we can collectively move up the value chain. The real question is whether our crumbling education system will be up to the challenge in the years to come.”

Aron has a similar perspective. “Many firms, such as IBM, are able to win contracts against their Asian and European competitors precisely because they have low-cost, high-quality centers in places in like India, China and in Eastern Europe,” he says. “In fact, their mastery of the multi-shore delivery model has evened the playing field for many of the U.S. firms against competitors from countries like India and China as well as from Europe and Japan. The question to ask policymakers in the U.S. is: Do you really want to handicap American firms at a time when they are facing intense global competition for large multi-billion dollar deals?”