Goods and Services Tax (GST): a game changer for the Indian economy

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After almost a decade-long wait, India’s Upper House approved in August the introduction of a unified goods and services tax, the GST. This landmark reform will ultimately make India a true single market, by replacing the multiple central and local taxes levied in each of India’s 29 states. It also marks a key achievement for the government, which managed to build sufficient political consensus with the states and opposition parties to reach the necessary approval by two-thirds of both houses.

Making India a true single market

Currently, India has a very complex, multi-layered and highly inefficient tax structure, which stems from its federal structure — the centre and states both charge multiple taxes at different stages of the supply chain.

Exhibit 1: India’s existing tax structure: multiple tax rates and exemptions

GST

Source: Nomura, GST Committee report, August 2016

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^ In addition to the standard and low rates, the central government also levies specific rates on certain goods. *States also charge a very low rate of 1% on gold. ** For services there is a single rate and 10 abatements.

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Under the goods and services tax system, nearly all multiple taxes will be merged into a unified four-tiered tax rate system. After the inevitable initial teething problems, this will simplify tax administration and collection to a huge extent for both the central and state governments.

Broadening the tax net and accelerating the transition from unorganised to organised: the GST is a destination-based indirect tax on goods and services that is levied on the value added at every stage from manufacturing to consumption. As each person in the value chain who gets an input tax credit then has an incentive to ensure that the previous person has paid taxes, the GST mechanism can lead to better tax compliance and a widening of the tax base. This could also accelerate the transition from unorganised to organised in many areas of commercial activity, especially in sectors with a high unorganised segment such as consumer discretionary, consumer staples, automotive ancillaries and textiles. The tax base should also be broadened by the narrowing of the tax exemptions that exist under the current taxation structure, which currently cost India about 2.7% of GDP.

Lower logistics costs

With the GST, businesses will be able to take logical decisions based on profitability and economics, rather than illogical ones based on tax concerns. According to a study by Credit Suisse, outbound freight costs for most consumer companies range from 3% to 5% of sales. The current supply chain is not optimal, as it has been created with the primary focus of avoiding interstate taxes rather than to optimise the distance travelled and the scale of operations. As a result, most companies have over 25 depots in India, whereas the country could be serviced from 10-15 optimally-located depots.

Implementation timeline

With both the houses having approved the bill and the states having ratified it, the next step is the finalisation of the GST rates, which is scheduled for November 2016. After that, the central and state governments need to pass the Central GST & Integrated GST and State GST bills, respectively. The IT infrastructure would then have to be put in place and testing done for implementation in the financial year starting in April 2017. While there may be a few months’ delay due to the short timeline and multiple parties involved at both state and federal levels, this should not have any impact on the long-term benefits that GST promises.

Limited short term risks outweighed by long-term benefits

Over the short term, the impact on consumption and growth could be disruptive and inflation could rise temporarily. The effective tax rate for services and the inclusion of the informal economy into the tax net could initially lead to higher prices. However, we expect this impact to be limited as the goods and services tax will impact less than 50% of the CPI basket. Moreover, there may only be a one-time adjustment of prices, and thus the inflationary impact may be short-lived.

While some financial market observers believe that India’s GDP growth could be hit in the first year following implementation, we believe that it will be neutral in the short term and should be accretive to growth in the medium to long term as benefits from the simplification of the tax structure, logistics and the transition of some commercial activity segments from unorganised to organised progressively materialise. Ease of doing business, better organised industries and one unified tax structure across the country could attract more investment, all of which would contribute positively to GDP growth.

This article was written by Paul Milon and Brijesh Ved.


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Brijesh Ved

Senior Portfolio Manager

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