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GST – Will it have an inflationary effect on Indian economy…

Economy | Published on Jul 01st 2017 | Comment(s) 0
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One of the big arguments against GST is that it tends to be inflationary by pushing up the prices of goods and services. At least, that is what the experience in countries like Australia and Malaysia was when they first implemented GST. But why exactly does that happen? One of the main reasons is that GST is a consumption tax rather than a production tax. When you tax a product at the manufacturing level (like in case of excise duty), the impact takes time to be passed on to the end consumer in the form of higher prices. On the other hand, in case of a consumption tax like GST, the impact of higher taxes is immediately felt on the price of the products. This is more so for products and services that are likely to see a tax incidence that is higher under GST than under the existing scenario.

While, these arguments are technically correct, there are four key reasons why the impact may not be inflationary in the Indian context, at least in the medium to long term. Here is why…

  • GST rates have been set in a non-inflationary manner…

One of the key statements made by the finance minister was that the GST rates will be set keeping in mind the rate of inflation in the economy. As a result, most of the food products like cereals, pulses, vegetables and even packaged foods have been kept in the lowest possible range of GST of 0% or 5%. This will help keep food inflation in check and that is crucial as it constitutes over 50% of the CPI inflation. More than 50% of the CPI food basket is exempted from GST. Even within the other items, the GST Council has taken pains to distinguish between necessities and privilege products. Thus sleeper class travel attracts lower GST than air-conditioned class. Similarly, economy flying attracts lower GST compared to business class flying. Even within the domain of toiletries and cosmetics, items of daily requirements like tooth-paste, detergents, soaps and hair oils have been classified in lower GST rate brackets. All these will go a long way in keep inflation subdued after the GST implementation.

  • ITC will mitigate the cascading impact of taxes on inflation…

One of the major benefits of the GST will be the input tax credit (ITC). Currently, tax paid on may service inputs are not available as a tax credit against the tax payable on the output. GST, being a value added tax, will change all that. The seamless availability of input tax credit will ensure that the cascading effect of taxes on inflation will be reduced and that will actually help to reduce inflation in the economy. At this point, it is hard to quantify the impact of ITC but it is certainly likely to be non-inflationary.

  • Don’t forget the anti-profiteering clause…

A very important part of the GST Bill is the anti-profiteering clause. What exactly is this clause? The anti-profiteering clause requires that any reduction in the effective tax rate post GST must be passed on to the end-customer. If a company that manufactures soaps is currently paying 20% effective rate of tax and if the GST under the new regime is 18%, then the 2% benefit must be fully passed on to the consumer. If the company chooses to retain the benefit, then the anti-profiteering clause will come into force and the GST Council has prescribed stringent penalties including cancellation of the GST registration, in case of such breaches. While one can argue that delineating the benefit is practically difficult, the fact is that it will act as a check against profiteering and also keep inflation in check.

  • There will be perceptible long-term benefits…

The best way to control inflation in the long run is through improvements in technology and process efficiency. That is exactly where GST fits in. To understand this point, let us go back to the experience of the last 20 years. The big boost to corporate efficiency in the last 20 years came from technology. Be it computerization, connected offices, ERP or Cloud, the theme of technology has been about lowering costs. In fact, inflation globally would have been substantially higher had it not been for the efficiencies brought about by technology. GST could play a somewhat similar role in the Indian context. Let us take the instance of a large FMCG company with offices, factories, warehouses and sales depots across India. Currently, this entire matrix is determined by the nature and structure of state-level taxes imposed at various levels. But that is, in reality, a sub-optimal approach. GST being a national tax does away with such boundaries. Hence businesses will focus more on creating distribution and logistics structure that are in tune with business requirements. That will mean a more efficient and optimal structure. When the case study of this single company is extrapolated to the entire economy, the efficiency gains can be phenomenal. That is where the long term anti-inflationary benefits of GST will become evident.

Over the medium to long term, the concept of e-way bill is also likely to be anti-inflationary. The e-way bill is a mechanism for end-to-end tracking of movement of goods above the value of Rs.50,000/-. This will almost give real-time access to scrutiny and will also ensure that costs are kept low. However, the IT backbone for e-way bills is yet to be readied and tested and hence GST may be launched without the e-way bill being operational. However, over the medium term, once the e-way bill gets launched, the actual impact on inflation will be more palpable.

The jury is still open on whether there will be inflationary shock in the immediate aftermath of the GST implementation. Going by the experience of other countries that have implemented GST, it is entirely likely when the entire nation suddenly shifts to a consumption based tax. However, such an impact will be more temporary as production and process efficiencies gather steam in the coming few quarters. That will be the key to the future trajectory of inflation post-GST!




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