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June 29, 2017

Indian Economy: GST and the bogey of inflation

The Modi government's biggest victory so far in economic reforms is – the passage of the goods and service tax (GST). Preparations are on in full swing for the July 1rollout of GST, the most fundamental and far-reaching indirect tax reform in decades. Though not in its ideal form, GST can usher in significant benefits, especially through a quantum leap in transaction trails and logistical efficiencies.

A four-tier tax rate structure – 5%, 12%, 18% and 28% – has been finalised, with essential items of daily use attracting the lowest rate and demerit/temptation goods, the highest. Luxury and demerit goods, such as luxury automobiles and tobacco, attract additional cess above the peak rate. Most mass-consumption goods will be taxed at a lower rate, and several essential food commodities have been exempted. A few petroleum products and alcohol are also out of GST's ambit.

From a macroeconomic perspective, the long-term impact of GST will be positively felt on efficiency improvement, widening the tax base leading to improved tax collections and fiscal health. It may lower inflation in categories where efficiency gains push productivity higher and costs lower. Specifically, GST could usher in significant efficiencies and benefits in the transportation and logistics chains.The cost will reduce for manufacturers, though it will increase for the services sector.In addition, GST will help narrow the gap between unorganised and organised firms, as input sourcing from compliant firms will be needed for tax set off.

In the short-term, however, there could be disruptions and likely loss of revenue for some firms as businesses transition to the new system. Small- and medium-sized firms could face initial hiccups in terms of getting onto the GST network, readying ITsystems, and understanding the effective tax incidence on their businesses. Also, lower thresholds imply that a manufacturer, service provider, or retailer who earlier did not face a tax levy, will now enter the GST net. This could push up costs.However, the big picture is favourable over the longer term as a GST environment facilitates ease of doing business or starting a business for smaller firms, who typically find tax laws daunting. Similarly, logistics cost is expected to go down.

In a nutshell, GST rollout will be a watershed event. While short-term hiccups cannot be ruled out, the efficiency gains will, over time, accrue across sectors, and the fiscal gains, as the net widens, will ensure the economy is a net gainer.