Explained: The Short, Medium and Long-Term Fallout of India's GST

How will India's sixteen-year-in-the-making tax system overhaul impact the economy, India Inc, the informal sector and the consumer? The Wire breaks it down.

Credit: PTI

How will GST impact industry, small businesses and the consumer? Credit: PTI

At the stroke of midnight on Friday, June 30, India’s goods and services tax (GST) will become official. The sixteen-year-in-the-making taxation system overhaul – which started with the Vajpayee government in 2000, later forged into existence by the UPA governments from 2007 to 2013 and finally shepherded through by the Modi government – is here now for better or worse.

The GST has been met with, in equal parts, trepidation and excitement – trepidation over the rush to implement it by July 1 regardless of whether India’s six crore small traders and businesses are ready. And excitement over its potential to formalise India’s economy, widen the country’s tax net and improve the ease of doing business.

What will be the impact and fallout of GST in the years to come? The Wire breaks it down.

GST – One Nation, One Tax. Yay or Nay?

India has both implemented and not implemented the spirit of a unifying GST. The GST subsumes a number of a central (central excise duty, countervailing customs duty) and state (state VAT, luxury tax, entry tax, octroi) taxes and thus prevents the dreaded cascading effect of taxes.

In spirit, therefore, there’s only one tax. In the pre-GST regime, a car manufacturer would have to pay a tax on his raw materials (say Rs 100) and a tax on his final output after creating the car (say Rs 130).

Under the GST regime, the car manufacturer can offset his ‘raw material tax’ against the ‘output tax’  – the total tax burden on the auto company would then become Rs 30 (Rs 130-Rs 100). This continues along the value chain to the wholesaler and then the retailer who sells you your car.

For consumers, India’s GST is one tax in the most practical sense that currently a bar of soap costs, theoretically, 29 different prices across 29 different states due to 29 different state VATs. Under the GST regime, there’s just one GST rate for a bar of soap: 18%.

Where India differs from other countries that have implemented GST is that there isn’t one single rate that applies to all goods or services. In Singapore, the tax levied on a pair of shoes and the tax levied on a bar of soap is the same – 7%.

Country Tax Rate
India 5%, 12%, 18%, 28%
Singapore 7%
Malaysia 6%
New Zealand 15%
Aruba 1.5%
Brazil 7%, 12%
Germany 19%

In India, the GST council has come out with a rather unwieldy four-rate structure: 5%, 12%, 18% and 28%. In addition to this, there is the exempt category (0%) and additional cesses that are charged on top of certain products, which makes our GST regime have seven effective tax rate slabs.

Why didn’t we end up with ‘one nation- one tax’ or a single-rate structure for our GST?

It wasn’t for a lack of advice; government or otherwise. In 2009, the 13th Finance Commission strongly recommended that India’s GST should be levied at a single rate of 12%. Six years later, the Expert Committee on the Revenue Neutral Rate for GST suggested a potential three rate structure while noting that of the countries that had adopted GST, 90% of them went with a single-rate structure.

Why, then, was this advice ignored?

Firstly, in order to protect existing government (both central and state) revenue. This is why nearly 60% of all goods under GST will be taxed at either 18% or 28%. And why nearly 20% of all goods are in the 28% rate bracket, a bracket that should have ideally only had classic luxury items or goods on which a sin tax should be levied. Instead, the 28% bracket has bulged to include non-essentials such as chocolates, chewing gum, shampoo, deodorant and paints in addition to the more typical items such as yachts and jets.   

This is also why key petroleum products and alcohol have been kept out of the ambit of the GST. Both bring in huge amounts of revenue at the Centre and state level and keeping them out allows governments to continue with constant tinkering to fill shortfalls in future budgets. The decision to leave out petroproducts is particularly disadvantageous for the average Indian consumer. As The Wire has pointed out, although global oil prices have steadily declined over the last six years, the Modi government has increased excise duties by over 150% over the last three years.

The final two reasons are that:

  • India’s poor needed to be protected
  • Various political considerations took a toll on GST

The first explains why both the 0% and 5% bracket exist and why 30% of the CPI basket and essential services are exempt.

The second reason, however, is why GST’s scope becomes unnecessarily unwieldy. The GST council and its ‘rate fitment committee’ was made up of politicians and central and state tax officials. They have worked very hard, as one commentator put it, to make sure the GST rate structure resembled India’s old tax system.

Which rates are the most troublesome? Will there be a wave of tax litigation?

Economists and market analysts believe that the existence of the 12% and 18% bracket – and their interactions with the 5% and 28% bracket – is problematic, giving way as it does to a lot of political arbitrariness and industry lobbying.

Under what economic rationale does the GST’s fitment committee justify keeping cashews and raisins at 5% but almonds and other nuts at 12%? Why are soaps and hair oils at 18% but detergents taxed at 28%?

And where there may be a social rationale over tax rate – for example, by taxing hybrid cars less than petrol and diesel-guzzlers – the government hasn’t chosen to act. Environment-friendly cars will not only attract the same GST rate as large luxury cars and SUVs but also attract a 15% cess over and above that.

Perhaps the most troublesome aspect is when the new GST regime believe taxation should be predicated on product pricing for non-luxury goods. A good example of this is how if moviegoers will pay 18% GST if they buy movie tickets priced under Rs 100 but 28% if they choose to opt for better seats (priced above Rs 100).

The logic against multiple rates is quite clear, as is evident from the GST council’s own flip-flopping over the last months on which items belong in 18% category and which should be taxed at 12%. Cutlery was initially put under the 18% bracket but later changed to 12%, while computer printers were shifted from 28% to 18%. Why were these decisions taken and do they really conform to the spirit of ‘one-nation, one tax’?  

A recent Bloomberg analysis has noted that the current four-rate tax structure will “spark a flood of litigation on everything from which tax brackets companies fall into to the revenue they generated”. This will likely add to the roughly 100,000 indirect tax appeals that have been pending as of March 2015.

What is the macroeconomic impact of GST on India’s economic growth or GDP growth?

This is difficult to state, party because it’s unclear how much the GST regime will change in the coming years. However, most economists believe a well-designed GST that ensured demand-driven production rather than tax-driven production could have added two percentage points to India’s GDP growth.

A US federal reserve paper even put it, too optimistically perhaps, as boosting GDP by up to four percentage points.

A more complicated GST, much like the one we have now, is likely to yield less favourable returns, more in the range of half a percentage point to one percentage point increase in GDP in the short-term. A recent analysis by HSBC shows that the rollout of GST is likely to add only 0.4% to GDP, “lower than earlier estimates as multiple tax rates and exemptions announced… are far from an ideal structure and could blunt the growth impact of the reform process.”

Will it curb tax evasion and expand the tax net?

There are two schools of thought here. The first is that India’s current GST regime goes against one of the more basic principles of increasing revenue: the lower the rate of taxation, the more number of people and businesses that will comply.

In other words, if the ideal taxation regime is the one that taxes more items at lesser rates, our new GST regime is far from that. Another closely connected issue is the GST threshold limit, which exempts businesses that make under 20 lakhs per year from GST. Top tax lawyer Arvind Datar pointed out in a recent speech how previous exemption limits were exploited under earlier tax systems.

“For many many years, we had a horrendous system of excise duty. Shampoo was taxed at 110% for instance. However, if your turnover was less than 5 lakh you had to pay no duty. What people did was, throughout places in Tamil Nadu like Cuddalore and Pondicherry, housewives would make up to 4.9 lakh and then stop. Or create multiple MSMEs within a family to get around paying duty. Multiple amendments had to come in to plug this loophole. With a 20 lakh threshold, you will have multiple enterprises like this mushrooming. Mrs Datar will have one business, my cousin will have one and my son will have one,” Datar said.

On the other hand, the other school of thought is that GST inherently increases formalisation in India’s economy, whether small businesses are ready for it or not. Industries, like textiles and clothing, that have historically paid little tax (whether in the form of duty or VAT) now have a formal GST rate and will have little choice but to start registering, formalising and digitising their business.

The GST regime is particularly good at formalising areas where India’s formal sector interacts with the informal industry through its reverse charge and input tax credit mechanisms. India’s biggest companies across various industries have incentives to bring their informal supply chain into the formalised tax net and vice versa.

The other crucial aspect is that while the exemption threshold is now Rs 20 lakh, for many small manufacturers it used to be Rs 1.5 crore, which means that thousands of hitherto informal or unorganised MSMEs will either shut shop or come into the tax net. GST, therefore, may or may not curb tax evasion practices but will almost certainly expand India’s tax net.

Which industry sectors aren’t ready for GST and which will be the most impacted?

The effect of India’s GST regime on specific industries depends on three primary factors. Firstly, sectors that have a high share of unorganised players will be worse off or at the very least have a lot more work to do. A crucial aspect of this is to what extent a particular small or medium business is vertically integrated and what percentage of the value chain in an industry is aggregated or disaggregated.

Secondly, sectors in which input tax credits have been removed or where it’s unclear how the mechanism will function will see short-term pain.

The third and final factor is the difference between the pre-GST and post-GST effective tax rate.

Table 1 below looks at three formal companies in the FMCG and retail sector. A company like Dabur that supplies a wide range of consumer products faces a number of GST rates. While on the whole, the changes in tax rates are neutral, the uncertainty around GST has led to a great deal of destocking, leading to potential weak volume growth in the first quarter.

Companies like Marico and Shoppers Stop which are having issues over tax credits and work with a bigger informal supplier base are expected to see low or negative growth, with supply disruptions expected as small vendors work their way into the formal economy.

Table 1: FMCG/Retail 

Company GST Rate Impact Preparedness Overall Impact
Dabur Overall neutral Dealers will be protected Weak volume growth in Q1
Marico Neutral to positive Teething issues over tax credits, small vendors aren’t compliant yet Low to negative growth expected
Shoppers Stop Garment prices to go up Large vendors ready, small vendors are unprepared Possible supply disruptions expected post-GST

Source: Edelweiss Securities

As The Wire has consistently reported and analysed, the GST rollout is proving to be everything from a headache to a nightmare for India’s small traders and businesses. This is seen across a wide range of industries as shown in Table 2 below.

Industries such as pharmaceuticals, plywood, tiles or luggage which have roughly 60-70% share of unorganised players will face a large number of transition issues in the next few months as smaller vendors hire legal and accounting help and board onto the computerised GST network (GSTN). Higher GST rates, such as the 28% rate for the luggage industry, will likely slow down the rate of formalisation while impacting sales in the next few quarters.

These problems don’t impact the cement industry specifically, which is largely filled with organised or large companies, although the construction industry might still have teething issues.

Table 2: Small Business Preparedness

Sector GST Preparedness Amongst Small Vendors Overall Impact on Industry
Pharmaceuticals Most participants in trade not geared up for GST India sales for industry will be impacted in Q1
Luggage Higher rate of 28% to slow down the pace of shift from unorganised to organised Post Q1, expect pickup from 7-8 July onwards
Cement Largely an organised sector and hence large dealers mostly compliant No major inventory impact expected
Plywood Dealers, distributors and vendors are not prepared for GST rollout Q1 FY’18 sales to be impacted
Tiles Transition stock related issues troubling dealers Margins to be impacted due to loss of input credit on gas and freight cost

The effect of the new GST rates play out in different ways – consider the tiles industry. It has been assigned a GST rate of 28% which is not too bad if you look at the existing VAT rates across different states. However, GST will likely prove to be inflationary for the industry as a whole because the sector’s biggest hub is in Gujarat which has a low VAT of 5% (leading to an effective tax rate of 17-18% after adding other taxes). With the loss of input cost credit availability for gas costs, the situation looks gloomy.

How will GST impact India’s informal economy and the sharply disaggregated value chain?

As pointed out, GST sharply impacts the intersection between India’s formal and informal economy. The basic principle is that the greater portion an industry is vertically integrated (where one company performs a lot of roles across the supply chain), the less pain there will be over the GST roll-out.

This is why while the core automobile industry may be largely unchanged post-GST (although there are issues with pre-GST stocks), auto ancillary industries such as automotive control cables will see teething issues.

Nowhere is this seen more clearly than the textile and fabric industry. Across India, in major textile hubs, traders and MSMEs that provide weaving, printing, processing and embroidering services are staging protests and bandhs.The usual problems that plague the overall informal economy exist in this industry too – worries over whether entering the tax net will eat into their meagre profits and the headaches that come with dealing with the sharp rise in paperwork and computerisation.

However, many separate analyses of Surat’s textile industry show that stakeholders in the “disaggregated value chain might end up paying as much as 20% more tax than a vertically-integrated company”. This is primarily because textile traders are too covered under GST, which means that tax will be levied on each intermediary transaction that occurs between the producers of yarn, weavers and processing mills.

What does this mean for job creation and the informal economy?

The basic problems for most small and informal businesses are similar: operating costs are about to go up as business owners hire accountants and computerise their operations. India has roughly six crore small firms, out of which 2.5 crore businesses will be exempt from GST as they won’t cross the Rs 20 lakh threshold.

However, according to Praveen Khandelwal, the head of the Confederation of All India Traders, a little over 50% of the remaining four crore firms don’t own a computer or are not digitally literate. What makes matters worse are the heavy filing requirements for service providers under GST.

As The Wire has noted, businesses will have to undertake 37 annual filings (three a month plus an annual return) for each state the firm operates in. The picture, however, is slightly better for goods providers, who can opt for the government’s composition scheme, which will allow them to file returns every quarter.

The bigger question is in quantitatively assessing the economic impact of forced formalisation of the economy. Anecdotal reports, varying from industry to industry, show that small firms with revenues of below Rs 1 crore could have 20% to 40% of their existing profits go towards GST compliance costs and higher tax rates.

However, it’s largely unclear at this point what extent of small businesses will simply become unviable post-GST. A recent Kotak equities report is not optimistic on what the new GST regime will do for job creation.

“We note that unorganised sector employs a majority of the labour force. With the unorganised sector shifting to the organised sector, a significant labour absorption capacity that currently exists may get eroded. This can compound the already chronic problem of job creation in India,” the report, issued to investors on Wednesday, notes.

What does GST mean for you as a consumer?

There are a number of item-specific comparisons that go into great detail on this subject. However, most economic analyses have indicated that the new GST rates should not materially impact inflation. Day-to-day essentials are largely exempt from GST (up to 30% of the CPI basket of goods and services are exempt).

Banking and telecom services will get more expensive and you will find eating out to be cheaper if you eat at a non-air conditioned restaurant (a GST quirk that builds on previous tax system quirks).

There are some clear winners (luxury cars, which will get cheaper), losers (movie tickets, especially regional cinemas, will get more expensive) and many goods and services that will largely remain the same.

A big factor in what will make things more expensive or not depends on what the item in question is.

For instance, soaps and toothpaste are supposed to get cheaper after the rollout of GST. They currently have an effective tax rate of 24-25% and after GST, this will come down to 18%. However, if as a consumer, you have always been paying say Rs 75 for a tube of toothpaste, it’s highly unlikely that the company that sells you the toothpaste or bar of soap will make it cheaper once you’ve gotten used to paying Rs 75.

To solve this potential problem, the GST legal framework creates an “anti-profiteering authority” that will check whether businesses are passing on the benefits of the new tax regime to consumers. Legal experts and industry leaders have almost unanimously declared that this anti-profiteering body will spark a minefield of litigation and prove to be problematic.