Benefits of GST

Despite the introduction of the Value-Added Tax (VAT) back in 2005, there are still multiple layers of taxes under the central and state governments. VAT rates also differ between states.

Firms face several taxes at each stage of production and distribution that are not always offset by input credits. This amplifies the net tax burden, adding to end costs. Services taxes also fall outside the purview of the VAT. The number of exemptions under the present system is arduous.

The GST is expected to iron out most of these wrinkles, helping to simplify the tax structure, encourage compliance, lower costs, improve efficiency and broaden the tax base. Taxes levied on inputs can be offset for taxes on the fin­ished goods and services, thus removing the cascading impact of multiple taxes.

Importantly, GST will include services and be levied at the point of consump­tion/destination rather than production. If the GST bill is passed in July or August, a GST Council will formalise the finer details by end-2016, including the official rate(s) and revenue sharing agree­ment. Implementation is likely to be completed next year.

Implications

The precise GST framework remains unclear. In its December 2015 report, a GST panel led by Chief Economic Advisor Arvind Subramanian, recommended a revenue neutral rate of 15.0-15.5% (excluding petroleum, real estate, alcohol and electricity).

An alternative three-tier option was also drawn out, under which a) lower 12% rate is applied on essential goods; b) 40% on luxury items (tobacco, luxury cars etc.) and c) remaining taxed at 17-18% (including services).

Noting that details still have to be ironed out, we discuss some of the macro implications.

Inflation

There is likely to be a short-term lift to price pressures, especially as service taxes are raised from the current 15% to 17-18%, while some product taxes are lowered. These adjustments however will partly offset each other, therefore lowering the net impact on inflation. Either way, there is bound to a temporary rise in inflation, which will typically last a year. This will wear off as these prices enter into the base, softening inflation the year after.

The price impact would be highest were a single GST rate to be adopted (with­out concessions). It is more likely that a tiered system would prevail, maintain­ing food and other essentials at low tax levels. Working with this assumption, GST changes would likely impact one-third of the CPI basket. The net change in effective tax rates would be highest for service and fuel products, accounting for bulk of the spurt.

Services are currently subject to 14.5% tax and for goods at the higher end of its standard 12.5-14.5%. If this basket (goods and services) is taxed at a higher 18%, inflation could bounce by 0.4-0.7% in the year of the implementation. Secondly, if the revenue neutral rate is set higher at 20%, an average 0.9% rise in the headline inflation is likely. Notably, manufacturers’ pricing power, exemptions and type of tiers will also influence the price pass-through.

There should be no permanent impact on inflation.

Growth

The GST impact on growth will likely be negative in the short-run but positive longer-out given the benefits of a unified taxation regime.

In the near-term, service sector tax rates are bound to rise and the sector ac­counts for over half of the economy’s growth. This will likely dampen consump­tion spending in its wake. Decisions on essential services like health, education, personal care etc. however cannot be put-off permanently, therefore imping­ing on growth only in the short-term.

Part of this hurt will also be offset by potential cost savings for the manufactur­ing sector (17-18% of GDP) due to a unified taxation system and availability of input credits. Here too, the extent to which these savings are retained or passed to the end-consumers will be determined by the firms’ pricing power.

Longer-out, introduction of the GST will be a positive for growth. A study com­missioned by the Thirteenth Finance Commission pegged the long-term boost to GDP growth at 0.9-1.7%. Our estimates are at the lower end of that range.

Intangible benefits of a shift to the GST system include a level-playing field for the manufacturing and service sector industries. Secondly a more unified taxa­tion system is good news for domestic and foreign investors. This will improve the ease of doing business, right from the simpler documentation process to facilitating inter-state trade.

The transportation/logistics sector in particular stands to gain. The GST panel report highlights a quarter of total travel time for road transport providers is spent at check-points (to pay inter-state taxes) and other official stoppages. Introduction of the GST and resultant elimination of state-specific taxation will lower barriers to trade.

Further, a unified taxation system will also lower cost disadvantages for do­mestic production. While the government has imposed countervailing duties and other taxes on imported inputs, this has failed to have the desired impact

Under the GST, exports will be zero-rated, while imports will be liable for GST payments. These measures cumulatively will be important for the government’s ‘Make in India’ initiative and plans to expand the manufacturing base.

Fiscal implications

Both the single rate and three-tier approach outlined by the GST panel are meant to be revenue-neutral. However in practical terms, there is bound to be some buoyancy in fiscal collections for state and central governments. The panel’s proposed rate is a combined rate, with the GST council to determine how this rate will be divided between the state and central governments.

Based on the ratio of GST revenues that needs to be raised, the panel suggests a 47:53 revenue-sharing arrangement between the central and state govern­ments, based on 2013-14 trends. This implies that the central government’s share in the pool of tax revenues will rise from the current 32% to 47% whilst the states’ reduces to 53% (from ~68% earlier).

Wary of such potential revenue losses, state governments have for long op­posed the adoption of the GST. Their chief demands include: a) keep revenue-generating products like petroleum and alcohol outside the GST. This is un­derstandable given that alcohol and petroleum account for a third of states indirect tax revenues; b) room to levy 1% surcharge over and above the GST to level the playing field between manufacturing and consuming states; c) seek compensation for revenue losses for the first five years.

The final say on the revenue sharing depends on the extent to which state gov­ernments will be compensated. The central government is still in negotiations to accommodate some of the above demands.

Conclusion

Moving to a GST regime will be beneficial for the economy on multiple counts. While a single-rate system would be ideal, it could prove difficult to pass. The government faces a fine-balancing act, as it works to reach a consensus with the state governments and opposition parties, whilst also ensuring higher taxes don’t impinge on growth/ incomes.

The odds are high that the authorities initially adopt a multi-tiered and diluted version of the GST. If so, a move to a single rate remains possible over the medium-term. Either version is preferable to the current VAT.

Source: Morning Star India(http://www.morningstar.in/posts/37623/gst.aspx)