Economic policy

Compounding a crisis

Print edition : October 27, 2017

Finance Minister Arun Jaitley listens to Chief Economic Adviser Arvind Subramanian as Minister of State for Finance Shiv Pratap Shukla looks on during the 22nd meeting of the Goods and Services Tax (GST) council in New Delhi on October 6. Photo: PTI

Members of the Tamil Nadu, Pondy Plastic Association during a demonstration in Chennai on August 9 demanding the withdrawal of 18 per cent GST on recycled plastic granules made from plastic scrap. Photo: B. Jothi Ramalingam

Members of the Akhila Bharatha Janawadi Mahila Sanghatane and college students protest against the levying of GST on napkins, in Bengaluru on July 11. Photo: V. Sreenivasa Murthy

At the Khari Baoli market in New Delhi. Demand for red chillies has been dampened after the Centre levied a 5 per cent GST on them. Photo: Kamal Narang

In the hands of the Narendra Modi government, economic policy has been reduced to disaster management following the wreckage caused by GST and demonetisation.

A DESPERATE NATION, reeling under the impact of an economic slowdown, was agog on October 6 as it waited for news from the meeting of the Goods and Services Tax (GST) Council. In particular, there were expectations that some sops would be on offer to soften the impact of the disastrous implementation of the new and “revolutionary” tax that was launched on July 1.

The three months of the new tax regime were a nightmare for most businesses, particularly small units, which have a presence in most parts of the national economy. Although a rollback was out of the question, the nation awaited some tangible relief from the massive burden that followed the already crushing burden that demonetisation was. Within Prime Minister Narendra Modi’s own State of Gujarat, in places like Surat, traders and manufacturers, especially of textiles, have been on the warpath, even if their protests have been blacked out in most mainstream media (see “A looming crisis”, Frontline, September 15, 2017).

Across the country, from poultry farmers and those in the pharmaceuticals trade in West Bengal to textile entrepreneurs in Tirupur, weavers in Varanasi, Modi’s constituency, to chikan makers in Lucknow, and powerloom operators in Bhiwandi to traders in Kanpur and Ghaziabad, people in business have been restive.

There was high drama as Modi summoned Bharatiya Janata Party president Amit Shah from his Kerala mission and went into a huddle with Finance Minister Arun Jaitley the previous day. Naturally, expectations of a “big bang” announcement were heightened; many, chastened by the sudden announcement of demonetisation last November, were also nervous because of the “anything-is-possible” fear associated with policymaking in the Modi era.

What actually came out of the council’s nine-hour-long deliberation could not have been more underwhelming. The council, nominally the apex body that governs the new tax regime (where it is the Finance Minister who actually calls the shots), offered some more elements aimed at fine-tuning what was heralded as a “revolutionary” tax.

The key elements of the changes—the latest being only the most recent in a long list of changes of tax rates on commodities and services and the rules for filing returns—indicated that the burden of GST on businesses was only going to get worse. The changes in rates were trivial because they were either wrongly aligned in the first place, or, like in the case of khakra, a Gujarati snack, were seen as pandering to an electorate that the BJP will be facing soon.

More importantly, the constant tinkering with rates right from the start of the GST regime does not reflect well on a tax administration. Businesses and consumers expect a stable tax regime, not one in an uncertain world in which anything can happen anytime. Moreover, by constantly tinkering with rates and rules, the tax administration appears to signal its amenability to lobbying by pressure groups and lobbies.

For instance, among the changes announced was the elimination of the need to present a proof of identity during purchases of gold or jewellery valued at up to Rs.50,000. Why would a government that swore to fight the black money menace, and which unleashed demonetisation in its name, want to pander to the powerful lobby of gold and jewellery merchants?

Exporters have been gravely hit by the GST crisis. Most of them, operating on wafer-thin margins, have been unable to recover the taxes they have already paid, and which need to be set off under various incentive schemes. It is estimated that about Rs.60,000 crore is stuck in the GST’s clogged pipeline since July. Jaitley has announced an e-wallet scheme, a system of “notional” tax credits against which exporters could offset their liabilities. But this merely amounts to applying band-aid to a gunshot wound because it is only an interim solution whose revenue implications are entirely unclear now.

Burden as relief

The other elements of the grand package unveiled by Jaitley after the meeting of the council, ostensibly aimed at offering relief to distressed small and medium enterprises, also reveal either an unwillingness to comprehend the plight of these units or, worse, a determination to proceed with a model that is designed to hurt them. Two elements in particular stood out as an indication of tokenism. The first was the decision to lift the threshold for the compounding scheme from Rs.75 lakh per annum to Rs.1 crore. Compounding essentially allows small business units with turnovers below the threshold to opt to pay a flat rate of tax ranging from 1 to 5 per cent depending on their activity (1 per cent for traders, 2 per cent for manufacturers and suppliers and 5 per cent for restaurants). About 1.5 million business units in the country out of 8.9 million assessees, or 17 per cent of the tax assessment base, had opted for the scheme. The increase in the threshold implies that at least one-fifth of the GST tax assessee base would fall under the compounding scheme.

The fact that these units face a less onerous burden in terms of filing returns—just one return every quarter and an annual return at the end of the financial year—may appear to make this an attractive option, but this is deceptive. Although compounding may imply a lower compliance cost, these businesses forfeit their right to claim input credits, which was tom-tommed as a highlight of GST. Business units can offset taxes (GST) paid down the line against their own tax liability. What this means is that those opting for the “convenience” of easier compliance are actually trading away their competitiveness, especially against larger companies that are fully integrated into the GST system. This is because smaller units’ costs would be higher, not simply because of lower scale but also because they suffer a higher incidence of tax. In effect, by increasing the compounding threshold, these units are actually in danger of bartering away their existence for immediate convenience.

That this is being touted as relief can only arise from a staggering suspension of reason. Moreover, the compounding scheme would not work for inter-State sales/supplies, which implies that small units would not have the option of accessing the wider national market via the so-called “one nation one tax regime”.

In line with this reasoning of offering relief, Jaitley also announced that business units with a turnover of less than Rs.1.5 crore per annum would only need to file quarterly returns, instead of the multiple monthly returns since GST came into effect. Again, this is hardly a relief, as millions of GST-compliant would testify, based on their experience with filing returns. The GST network has been erratic and has demonstrated its inability to cope with the concentrated rush of taxpayers close to deadlines for filing returns; so much so that Jaitley has had to extend deadlines for filing returns multiple times in the short span that the new tax regime has been in existence.

The relief that Jaitley has offered actually implies an additional burden to beleaguered business units. These units will now have to wait for a quarter before they can claim input tax credits. In order to comprehend this impact, it is necessary to appreciate that working capital is critical for these units and the shortage of this kind of capital, to pay for wages, inputs and raw materials, has always been a problem for these units.

Moreover, the inordinately delayed payments made by large companies for supplies received by them can only be described as a parasitic relationship between large and small units in the country. The small units’ limited access to banks for their working capital needs worsens this situation. In fact, this is a primary reason why cash played a central role in the fortunes of these small units, until demonetisation hit them. Lakhs of business units across the country, across industries from textiles, leather and paper products to plastics and others, were hit hard by demonetisation because cash was their medium of doing business.

What GST has done is to add another layer of working capital expenses to these companies. If units have to wait for payments to come in, or for tax credits to flow back as offsets to their tax liabilities, they will need more working capital to tide over the interim period. The fact that many of these units operate on wafer-thin margins makes this a tight stretch.

A recent study by India Ratings and Research, part of the Fitch Group, a global rating agency, shows that the burden of GST in sectors such as textiles, steel, consumer durables and construction is falling disproportionately on smaller units. In fact, it notes that the wave of discounts offered before the GST rollout was to reduce the uncertainty that was expected to pose problems by way of locked-up input tax credits. It observed that in sectors such as construction, consumer durables and metals, the interest cover available to tide over delayed receipts of input taxes are “a cause of concern”, especially for smaller units.

In the case of steel, India Ratings expects that under the impact of GST, the playing field would be tilted in favour of larger companies as the pricing gap, currently at 5-7 per cent, “is likely to fade”. The market share of unorganised steel producers is likely to fall sharply because of their higher compliance costs and higher cost of working capital. The case of textiles is particularly striking because the double whammy of demonetisation and GST has rocked the entire supply chain.

“GST has knocked the stuffing out of us, not just me but all along the chain I am part of,” a textile retailer in Bengaluru said. Before GST, he stocked according to what he reckoned was likely to sell, based on his reading of what was fashionable. The business ran on the understanding that unsold stocks would be returned to the wholesaler and payments in subsequent time periods would be netted out against fresh supplies. This logic worked backwards right through the chain, from the retailer to the wholesaler and to the manufacturer.

Flawed design

The GST regime straitjackets the entire process by insisting on the matching of every single invoice down the chain. Such a system of invoice-level matching is unheard of in any GST regime anywhere in the world. Apart from introducing an additional burden of compliance, it also adds to the uncertainty. The owner of a small business who bought a car for his company in August said that he had to ensure that the car dealer actually entered the details of the invoice for him to be able to claim tax credit. “Why should I be burdened by somebody else’s tax filings even though I have paid all my taxes?” he asked.

The textile retailer in Bengaluru said that in his case, the requirement of matching individual tax invoices with counterparties resulted in reduced flexibility and higher risk. “Since I am unable to sell a portion of what I ordered from the wholesaler, and since he is unwilling to take it back, I now avoid risk by stocking less,” he said. “This is happening not just with textiles but in every other trade. Everybody wants to avoid risk, especially because they are already reeling under a severe working capital shortage. Why does it surprise you that the economy is slowing down?”

GST apologists say that invoice-level matching is necessary because it eliminates the possibility of tax avoidance or tax theft by entities. They point to China as an example where this is the norm, but do not mention that the Chinese system requires all entities to use the same software, which ensures simultaneous and instantaneous resolution of tax payments and claims. In most countries, the norm is to use an intelligently determined small sample to check the veracity of claims instead of clogging the entire system by demanding that every single invoice be matched with a counterparty’s entry.

This is a serious design flaw that the Indian GST suffers from. More worryingly, there is no indication that either the Finance Ministry or the tax administration is even addressing it.

The other major aspect of the GST crisis, again a design flaw arising from the Modi government’s failure to pursue GST as a long-term reform, pertains to the multiplicity of tax rates. The constant tinkering with rates reflects two aspects of the mindset of those implementing GST. At one level it arises from the GST design, which simply puts different commodities and services into tax rate buckets closest to rates prevailing before GST came into effect. In the process, GST as a reform took a backseat, ceding ground to a perspective that demanded revenue “neutrality”—that is, there ought to be no loss of revenue from the new tax regime.

Instead, a more sagacious approach by the Centre would have helped. Such an approach would have required the Centre to focus less on revenue mobilisation in the short and immediate terms on the understanding that it was undertaking genuine tax reform. Of course, such sagacity would have also required it to protect the States from revenue losses because, after all, they were ceding their tax-raising powers.

Uprooted supply chains

Apologists of GST in general, and Modi’s ardent followers in particular, have been gloating that demonetisation and GST, by “formalising” business, has done the economy a great deal of good. The reality is very different. Among the datasets that have come to light recently is one showing how imports have surged in recent months; in particular, non-oil imports have increased significantly. These apologists see this as an indication that a recovery is in progress.

Instead, the surge indicates that imports have quickly occupied the supply chains, whose constituent units were devastated by the twin burdens of demonetisation and GST. This is not because the units were necessarily “inefficient” but simply because demonetisation destroyed the very fuel on which their businesses ran. Even before they could recover from the effects of demonetisation, GST hit them because they were desperately scrounging for their working capital needs. It appears that the GST regime, by severely disrupting their supply chains, allowed for imports to fill in this gap.

Modi apologists, in the aftermath of demonetisation, claimed that the move was a great one but that it was badly implemented. If only more currency notes had been printed, if only the ATMs had been calibrated sooner, if only banks had worked more efficiently… so went the line of reasoning. A similar tune is now being sung by those supporting GST.

While much is wrong with the functioning of the GST network, which collapsed at crucial times in the returns filing cycle, the real problem with GST lies in its conceptual design.

This is most striking in the way it treats economic entities without any regard to their size. It appears to be scale-neutral but it actually tilts the balance against smaller entities of all kinds and in all sectors of economic activity by imposing costs on them. Seen from this angle, GST is not just not neutral, it is positively biased in favour of big business and thus promotes concentration of economic power.

The recent remark by Piyush Goyal, who, instead of being more worried about the responsibilities of the Railway Ministry, especially after being welcomed recently into office by a spate of derailments, said that rising unemployment among youth was a “good sign” because it reflected the aspiration of youth to become entrepreneurs instead of just looking for a job, is shocking for two reasons at least.

First, the Indian economy could not have been worse for entrepreneurs. It is not just small manufacturing units, textile and garment units or factories or hotels that have faced the brunt of the twin shocks: there have been fewer software start-ups this year compared with last year and reports indicate that funding has dried up. Second, the kind of jobs Goyal was referring to—3D manufacturing and artificial intelligence—are hardly jobs that the average Indian can access on demand. Goyal’s comments reveal the extraordinary distance that has emerged between the political elite and the ordinary citizen, where wishful “aspirations” masquerade as policy, the Bullet Train being just one example.

Well before the current political crisis, triggered by the scathing comments made by former National Democratic Alliance Ministers Yashwant Sinha and Arun Shourie, Jaitley suggested that GST-like reforms were continuous in nature. Implied in this was the suggestion that it would be fine-tuned along the way. This is a far cry from how Modi unveiled GST, invoking India’s second “tryst with destiny” at a midnight session of Parliament. In Modi’s original promise made a few months ago, GST was a revolutionary step. In reality, this so-called tax reform is reform, drip by drip. The only thing that is certain about this fatally flawed and badly designed tax is that it will hurt more.

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