GST: Are we overplaying its impact?

There is renewed optimism regarding passage of the long-delayed Goods and Services Tax (GST). With most regional parties seemingly in favour of the GST and the Congress party showing signs of softening its stance, it is likely that the constitutional amendment bill will be passed in the monsoon session and the transition to GST will happen from 1 April 2017. If this indeed happens, it will be positive for the economy. GST will ease compliance and remove distortions between goods and services and across states. All of these are good enough reasons to implement GST. However, there is a real risk that we might be overplaying the impact of GST on the economy. While the transition to GST is important and beneficial to the economy, the GST is not, as we have heard from a few people, ‘the single most important economic legislation since independence.’ Economic reforms are a process and not a destination. Thus, it will always be ‘work in progress’. There is not a one single measure that will solve all our economic problems overnight. 

We discuss below a few issues where expectations from GST may have run ahead of what it can deliver. 

GST will boost GDP growth by 1-2ppt (in perpetuity): This is an oft-quoted benefit from the implementation of GST. Yes, GST will boost growth. However, the magnitude is unlikely to be anywhere as significant as this. We should remember that long-term economic growth comes from a combination of two things – more investments (physical or intangible) and/or improved productivity. Both of these are incremental things and not annuities as far as growth is concerned. For example, a country invests in a new machine and that machine will increase GDP growth rate as it ramps up production. However, once it has reached full capacity, growth will be down to zero (assuming other things remain unchanged). Similarly, if we are able to produce 11 units of goods per hour instead of 10, it will result in faster growth. However, if productivity stays at 11 units thereafter, growth rate will fall to zero. The same will be the case with GST, as businesses align to new tax structure, there is likely to be a step-up increase in output pushing up growth rate, but it cannot continue in perpetuity. 

So where does this 1-2ppt number come from. The source of this number seems to be an NCAER study (http://bit.ly/29u4awd), which analysed the impact of a GST (all goods and services covered with little or no exemptions and a very low rate of tax) on the economy and foreign trade. The current GST design is far away from that ideal design and this in itself negates part of the study. More importantly, the study finds that GDP (level) will go up by 1-2% (or thereabouts) and not GDP growth rate. This small detail has unfortunately got lost. Thirdly, this is just a mathematical model of the economy. The real world impact depends on so many moving parts that it is probably impossible to quantify the impact of GST. As the paper mentions at the end: “the results must not be read as forecasts of variables but only as indicative directional changes”. It is quite possible that the impact of GST on GDP growth is imperceptible in even the first year. However, this is not necessarily a bad thing. 

Possible negative impact of GST (at least in the short run): There are two factors that could actually result in GST affecting the economy negatively, initially at least:

 • Firstly, if the immediate impact of GST is that it will compress supply chains (by making them efficient through either lower transport time or optimal location of warehouses etc.), it will actually reduce output to that extent due to inventory destocking. This is good for productivity in the economy and for cash flows for businesses. However, statistically at least, it is not good for growth. 

• Secondly, GST is designed to collect the same amount of taxes as before and a large part of the discussion of the impact of GST stems from the effect of redistribution of tax burden. Now, if the popular narrative, that there are a large number of ‘unorganised’ (and small) businesses that evade taxes due to loopholes in the current tax structure and will have to pay taxes under GST (and this will be offset by organised businesses seeing a lower rate of tax), is taken at face value the question that arises is whether redistribution of tax burden positive or negative in aggregate. For instance, let us consider an increase in tax burden of a local soap maker by say Rs100 as he starts to pay tax under the GST and a concomitant reduction in tax burden on a large organised soap manufacturer. The impact on the economy depends on whether it affects their relative profitability. And if it does affect their profitability, how does that impact their consumption/investments? Is the marginal propensity to consume/invest more for smaller (unorganised) businesses in general than for larger businesses, is it lower, or is it the same? 

GST will ipso facto benefit the organised sector at the expense of the unorganised sector: We think it is too simplistic to assume that GST will benefit the organised sector at the expense of unorganised sector. 

• Firstly, it is not clear what exactly is meant by ‘organised’ sector. To many, the organised sector comprises listed companies and to some it comprises branded sellers. However, the assumption that just because the competitor is small, it is unorganised and just because it is unorganised, it competes by evading taxes is too simplistic.

 • Secondly, and more importantly, the point many miss is that the key factor that is expected to benefit the organised sector under GST— input tax credit—already exists under the current taxation structure. In case of goods trade, state tax is already a VAT and businesses get credit for taxes paid on their inputs. Even Excise duty is a VAT levy as manufacturers get credit for excise duty paid on inputs.

 Admittedly, the current chain of input tax credit is not perfect and seamless as it will be under GST. This is especially the case for services trade where input credit availability itself is limited currently and in the case of inter-state trade in the case of goods. 

So yes, there will be a more seamless chain of input tax credit under GST, which will further incentivize businesses to buy their inputs from ‘organised’ players; but at least for goods trade the change will largely be incremental.

 Another related point is, given that GST structure will have exemptions. Thus, the input tax chain will be broken whenever businesses are either buying from or selling to industries not covered under GST. Consequently, the organised/unorganised logic will also break down in these cases. 

GST will eliminate border check posts and speed up the movement of goods across the country: We think it is too simplistic to assume that once we switch over to GST, goods will start to move much faster across the country. For one, state borders are not going to be closed following GST. This is because many items such as petroleum and alcohol will continue to see state-level taxes rather than GST.

However, these factors can be eliminated if the GST structure is improved by removing exemptions. Nevertheless, state checkpoints also exist for other reasons such as security. The 13th finance commission under chairmanship of Dr. Vijay Kelkar observed the following in the context of state check posts under a flawless GST (without any exemptions and a single rate): 

“Most states have put in place a system of checkposts on their border roads. There are a number of reasons for putting in place such physical barriers to trade. ...The onset of GST will not obviate all these reasons, and therefore, check posts on state borders may remain.” 

Another thing to note is that the conventional assumption that state border check posts slow down movement of goods across the country may not necessarily be true. This Business Standard piece (http://bit.ly/1SwcfQP), which tracks a truck moving from Delhi to Mumbai—amongst the busiest route in the country—suggests that the way truck drivers are paid (per trip basis, inclusive of fuel) influences the time taken. It is possible that this is just a bad example, since this is just one data point. However, prima facie, it does raise a legitimate question to a current widely held belief. Then there is the case of poor road infrastructure, which slows down movement of goods (although road quality has improved considerably at least on the main trunk routes). On balance, although GST will speed up movement of goods across state borders, expecting a significant closing of the gap vis-à-vis developed countries or China, overnight is taking it way too far. 

So what about the GST: Given our above reservations, we believe that we should look at the current GST as work-in-progress rather than an end in itself. Overtime, hopefully, more items will be included in GST and some of the negative aspects of the current GST such as 1% levy on inter-state trade will be eliminated. Further, the GST itself should be looked upon as one of the several small things the government needs to do as part of its reform agenda. There isn’t one single reform measure that will result in economic growth accelerating over night. Rather, there are several small steps, of which GST is one, which the government needs to do. The cumulative effect of many of these small reform measures (and many small things have already happened even before GST) will take us to a tipping point at which growth will start to accelerate.

(Disclosure : Published in 2016, © India Infoline Ltd 2016)