India’s new Goods and Services Tax (GST) will unify the indirect tax system and remove domestic barriers to trade, which should support productivity gains and GDP growth over the long term, says Fitch Ratings.

The GST that came into effect on 1 July is relatively complex, including multiple tax rates for different goods – ranging from 0% to 28%, or higher where ‘sin taxes’ are applied – and requires frequent filing in all states in which a company operates. Nevertheless, it is far simpler than the previous system, under which each state set its own sales taxes – in addition to the central government – and imposed border taxes on goods entering the state.

The unified national system should offer significant opportunities for productivity. For example, it will become much quicker and less costly to move goods across the country now that trucks will not be held up at checkpoints at state borders. Smoother logistics should reduce retailers’ need for working capital and allow them to operate centralised warehouses, rather than in every state. Supply chains could extend, encouraging specialisation, now that there is less incentive to source goods within state borders. Tax filing may also become less time-consuming as a result of the new electronic system.

The GST is unlikely to increase revenue in the short term. However, it is likely to boost revenue indirectly over the long term, as it supports GDP growth and encourages tax compliance. A benefit of value-added taxes like India’s GST is that retailers are required to show compliance right along the supply chain to claim refunds. Large companies will now have an incentive to pressure smaller suppliers into compliance. The new electronic filing system is also likely to lead to more tax reporting. Moreover, the tax base will be broadened, as only SMEs with sales of INR2 million (USD31,000) will now be exempt from paying GST, down from INR15 million.

Small informal retailers – which account for over 90% of retail sales – should also find it harder to understate their sales or to avoid filing tax returns altogether in a system where transactions are tracked throughout the supply chain. This could accelerate the shift toward organised retail.

Shifting activity into the formal sector, where activity is regulated and taxed, is a key government goal and was the main motivation stated for demonetisation in late-2016. The informal sector is very large, accounting for over 20% of GDP and 80% of employment, and is largely untaxed. This is one of the reasons why government revenue is low, at just 21.4% of GDP in 2016, compared with a median of 29.9% for ‘BBB’ range sovereigns.

There are significant short-term risks involved in the GST implementation, emphasised by the late changes to the bill and the disruptive roll-out of demonetisation. High compliance costs for businesses and administrative difficulties have been problems in some emerging economies that have introduced value-added taxes, particularly those that had complex systems, under-resourced bureaucracies and short lead-in periods.

India’s new system will overhaul the way businesses operate, affecting their financial reporting, tax accounting, supply-chain management and technology requirements. Contracts will also need to be renegotiated. Smaller firms, many of which still keep their books manually, are likely to find the transition particularly difficult. India’s large bureaucracy is likely to be tested by the new system, with further potential implications for businesses. For example, delays in processing tax returns and paying out refunds might create cash flow problems. Multiple GST rates are also likely to lead to disputes over which goods fall into which category, which could add to strains on the judicial system.

Source: Fitch Ratings