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June 07, 2017

EcoView: GST and the bogey of inflation

This report is available to users in India for ₹5,000 + applicable taxes

 

GST is here, will it stoke inflation?

 

Apart from good rains, July will also see the implementation of the Goods and Services Tax (GST) after more thana decade of pre-legislative back and forth.

 

To be sure, the medium-to-long term impact of GST will undoubtedly be benign. But it’s the short-term hiccupsand disruptions that are a source of concern. Though not in the ideal form, GST is still the most fundamental and far-reaching tax reform in decades. Over the medium term it will push growth, reduce inflation, improve taxbuoyancy and help exports become more competitive.

 

In the short run, however, there are worries on what it could do to both inflation, and small and mediumenterprises.

 

This month’s theme examines the short-term implication of GST on inflation.

 

By now, it is common knowledge that most mass-consumption goods have been taxed at a lower rate, and severalessential food commodities exempted.

 

To get a better sense, we mapped the GST rates with the disaggregated items in the consumer price index (CPI) basket to see which items face a higher tax rate and where the incidence could be lower than earlier. About 20%of the CPI basket could see a bump-up in inflation during the GST adoption phase. These are items where taxincidence will be higher after GST is implemented, and already have higher inflation. For others, the impact islikely to be neutral to a decline in inflation.

 

One of the fears about GST implementation is that the unintended impact of changes in tax rates on consumerprices could be disrupting and could linger due to asymmetry in transmission of tax rate changes to the endconsumer. That’s also the reason why it is difficult to conclude on the inflation impact of GST. Domestic demandconditions have been sluggish for a while, and the pricing power of manufacturers is weak. This creates thepossibility that manufacturers may prefer to not immediately pass on the benefits of lower taxes to consumers.The government intends to tackle this via an anti- profiteering rules.

 

Nevertheless, the rollout of GST will be a watershed event.

 

While short-term hiccups cannot be ruled out, the efficiency gains will, over time, accrue across sectors, and thefiscal gains, as the net widens, will ensure the economy is a net gainer.

 

Consumer inflation fell to a five-year low of 2.2 % in May, 2017. Despite the decline, the Reserve Bank of India(RBI) stayed put on repo, its signalling rate. The RBI believes the drop in inflation did not warrant a rate cut, saying,“premature action at this stage risks disruptive policy reversals later and the loss of credibility”.That said, easy liquidity conditions have de facto softened rates, even without a formal lowering of the repo rate.Also, lower risk weightage for housing will help support demand for homes. But what undershooting inflation doesfor sure is rule out a rate hike in the foreseeable future, so the RBI’s stance would, in effect, be accommodativethan neutral for now.

 

Inflation could fall to below 2% in June and if this trend continues, doors will open for a rate cut in the August policy.