Reform the GST in 2019!

The challenge for 2019 is to push up the growth rate from the present seven percent. Economic growth is basically driven by demand. There is demand for cloth and cement in the market if people have the money to buy garments and build houses. This demand leads to an increase in prices of garments and cement and makes it profitable for the businesses to invest in new textile mills and cement factories.

These factories create employment. Workers are paid wages with which they buy more garments and build more houses. In this way, a virtuous cycle of demand and investment is put into motion. This virtuous cycle is presently broken by GST in two ways.

One, the Medium, Small and Micro Enterprises (MSMEs) have come under stress and less employment is being created and there is less demand in the market. Two, the move towards a single rate of GST will increase the tax burden on the poor and lead to a reduction in demand.

According to the annual report of Ministry of MSME, the share of MSME in GDP was 29.6 percent in 2011-12. It declined to 28.8 percent in 2015-16. The MSMEs are creating bulk of the employment in the country.

According to the Ministry of MSME, the employment generated by MSMEs in 2015-16 was 11.2 crore. In comparison, according to the Economic Survey published by the Ministry of Finance, the employment generated by the (Large) Private Sector was only 1.2 crore in 2012-13.

Thus, MSMEs are generating ten times the employment created by large industries. The weakness of MSMEs, therefore, has translated into fewer jobs, lesser demand and broken the virtuous cycle of demand and investment.

The GST appears to have led to a further deterioration in the share of MSMEs in GDP —which was already sliding earlier as above data indicate. This is a global trend. A study by Victoria University found that MSMEs in Australia spent 3 percent of their total revenue in making compliance with the GST—that is about one-third of the profits earned by them.

Five out of six MSMEs said that their condition was worse than earlier. A study by the University of Wellington found that the distributional impact of the GST on MSMEs in New Zealand slightly regressive — meaning a higher tax burden on them.

A study by Monash University in Malaysia found that the some MSMEs “voiced their concerns over the closure of small or traditional businesses, mainly due to their inability to manage the GST requirements, coupled with anxiety and fear (psychological costs) over the costs of non-compliance.” Similar studies are available from Norway, Singapore and the European Union.

Anecdotal evidence suggests that the situation in India is similar, if not worse. There is a need for the government to rescue the MSMEs from this decline otherwise the reduction in employment will become a social disaster in addition to an economic one.

The government must allow the MSMEs to obtain refund of the GST paid on inputs even if they pay only 1 percent GST on the sale under the Composition Scheme. Secondly, the government must allow MSMEs to pay GST when the customer makes the payment, not when the MSME raises the Bill.

The government proposes to merge the multiple GST rates into one single rate so that tax administration becomes simple, businesses have less difficulties in compliance, the economy becomes smooth and growth rate picks up.

A single rate of GST means that Mercedes car and milk will be charged at the same rate. Till now we have taxed the goods consumed by the rich such as Mercedes car at a higher rate, and goods consumed by the poor such as milk at a lower rate. Thinking was that the poor will have more cash left in their hands and their welfare will be protected.

There is also an economic dimension to the different rates of GST. Let us say Ratan Tata loses Rs 1,000 from his wallet. His consumption will hardly be affected. But, if a peanut seller loses Rs 1,000, he will immediately have to cut his consumption of shoes, cloth or milk.

A single rate of GST will lead to a reduction in the tax burden on the rich with no increase in consumption by them, and an increase in tax burden on the poor and a reduction of consumption by them. The total consumption will decline and, once again, break the virtuous cycle of increased demand and investment.

We are caught between two contrary impacts of the single rate of GST. On the one hand it will simplify the tax administration and lead to higher rate of growth. On the other hand, it will lead to increased tax burden on the poor and to lower rate of growth.

This problem has been confronted in many countries that have wanted to move to a single GST rate. A study by the Inland Revenue Department and the New Zealand Treasury says that lower rates of GST on goods consumed by the poor indeed leads to lower tax burden on them but “welfare transfers are generally considered a more targeted and simpler way of addressing distributional concerns.”

A study for the United Kingdom done by Nobel Laureate James Mirrlees concluded that “the poor would be much better supported if the government were to remove the lower tiers of VAT on various items that the poor consumed, and instead help the poor more directly instead.” A study for Bostwana done by Sheridan College, Australia and University of Canterbury, New Zealand suggested that Bostwana should adopt a single rate of GST and “consider introducing income supplements and welfare payments” in order to assist the poor for the increased burden of tax.

These, along with other studies from across the world, suggest that the way to reconcile single rate of GST with equity is to simultaneously introduce direct benefit transfers in cash to the poor. Such transfers would prevent a reduction in demand due to the increased burden of tax on the poor. The Finance Minister is on the right track in moving towards a single rate of GST, but the precondition of its success depends on simultaneously introducing direct cash transfers to the poor.

The challenge for 2019 is to bring the economy back on to a high growth rate. The government should immediately allow MSMEs to get cash refunds of GST paid by them on the inputs and to pay GST when they receive payments. This will revive the MSMEs, create employment and demand.

Two, the government must institute direct cash transfers to the poor and only then move to a single rate of GST. That too will maintain, if not revive, demand and unleash a virtuous cycle of demand and investment leading India to double digit growth rates. Author was formerly Professor of Economics at IIM Bengaluru