Timely Stimulus

Ahead of the meeting of the Goods and Services Tax (GST) Council, Finance Minister Nirmala Sitharaman had done her math and worked out her response to the inevitable demand that a likely reduction in revenues following a general lowering of rates be matched by a compensation regime. The experience of the five-year compensation period after GST was introduced in July 2017 was not good. The payouts were often marked by bickering and claims of delays and underpayment. The compensation regime was unwieldy and could become a habit hard to shake off. The GST reforms were to simply rationalise tax slabs and reduced rates were a bold gamble on spurring growth amid global uncertainty. 

When Karnataka and Kerala called for a compensation mechanism for an estimated ₹48,000 crore revenue forgone—the actual loss in collections could be higher than the 2023-24 calculation—Sitharaman said there was no such proposal. The populist appeal of the sweeping rate reductions was such that objections melted away and the GST Council wound up its affairs on the first day of its scheduled two-day meeting. The Centre had gone over the arguments. The compensation cess when GST was launched was intended to assuage states over anxieties about how the tax on consumption will play out. Sitharaman was quick to point out that states benefitted from compensation when Covid struck. After all, there was no compensation mechanism when the sales tax regime was in place. 

The reformed GST was seen to have settled the “popcorn” debate as well where the loose, packed and caramelised product attracted different rates of interest. Officials familiar with the working of GST point out that the case was overstated and that while rate rationalisation was desirable, costlier packaged foods were a different category. Yet, they agreed that the new GST cut through the clutter by adopting a Gordion Knot approach. It did away with the bureaucratic tendency to split hair and allow worries over revenue loss to paralyse reforms. Though administrative matters continue to demand attention, Prime Minister Narendra Modi’s optimism over a “double Diwali” does not seem off the mark given overtures by corporates to offer the reduced prices in advance of the September 22 rollout. 

When Modi made a surprise announcement of the forthcoming GST reforms from the ramparts of the Red Fort on August 15, he set off a wave of expectations among consumers and businesses alike. In his speech the prime minister announced a revamp of the GST regime to make it more attractive for everyone. He said, “…the need of the hour is that we should review it [GST] once. We started the review by setting up a high-power committee and also held discussions with the states.” He set the ball rolling for a final view a few weeks earlier by asking Sitharaman to prepare proposals and bring lengthy discussions to a conclusion. 

True to his word, a fortnight later, the GST Council met in New Delhi and made a series of far-reaching recommendations. In a swift and smooth meeting, the council recommended the abolition of the 28 per cent and 12 per cent tax brackets to a simplified, two-tier structure with a merit rate of 5 per cent and a standard rate of 18 per cent. The special “de-merit” rate of 40 per cent will continue for a handful of items. Of the 506 goods subjected to tax changes, recommended by the council, 90 per cent will see rates being reduced. Sources pointed out that previous cesses had actually resulted in an effective tax rate of more than 40 per cent on some items labelled as “sin goods”. 

Items of daily consumption such as hair oil, toilet soap bars, shampoos, toothbrushes, toothpastes and other household products will see GST being reduced from 18 per cent or 12 per cent to 5 per cent. Then there are items of middle-class consumption, such as air conditioners, large-screen TVs, dishwashers, small cars and motorcycles (less than 3,50cc). GST on these items is being reduced from 28 per cent to 18 per cent. In reality, these are no longer middle-class consumption items and are more in the nature of “aspirational goods” for a large number of consumers as there is a high degree of saturation for these goods in urban markets. With this 10 percentage point reduction in GST for these items, they will become accessible to a much larger number of buyers.  

The political impact of the reduced prices, the government hopes, will provide wind to the sails of the Bharatiya Janata Party ahead of the Bihar election due soon. Lower prices for motorcycles that are popular in smaller towns and rural areas are a sure win. The extent of revenue loss will become clearer over the months, but it was equally important to keep consumer sentiment upbeat and prevent issues such as the US tariff assault from pushing the economic sentiment into a funk.   

It would be a mischaracterisation to describe the rate changes as purely middle class-oriented. Important—and politically volatile—sections such as farmers, too, have received a bonanza. GST on equipment such as tractors, machinery for soil preparation/cultivation, harvesting and threshing machinery, including straw and fodder balers, grass mowers and composting machinery among a host of other items has been brought down from 12 per cent to 5 per cent. 

At the moment, the government is in a mission mode to crease out the difficulties that any such major transition in the tax system is certain to introduce. Some examples illustrate the issues at hand. A long pending demand from different sections of consumers has been that GST on insurance products. The council has decided to waive off GST on all such products: health and life insurance, including reinsurance on them. Earlier, these products attracted 18 per cent GST. The interim problem is one of insurance companies incurring losses as they will no longer be eligible for Input Tax Credit (ITC).  

While these companies will continue to require administrative and other services, they can no longer claim ITC as GST has been abolished on the products they sell. Will this lead to those costs being passed on to buyers of insurance? How will the ITC problem be solved? The government is busy ironing out these problems. In fact, Sitharaman has repeatedly stated she will personally monitor the pricing situation after the GST changes kick in following September 22. Other ministries, too, are busy with that exercise. 

There has been plenty of speculation over the timing of the announcement. Why did the prime minister make that announcement on August 15? Why not earlier? Why not later? There is no end to such speculation, including remarks that why the announcement was not made in Parliament. (Parliament has no role to play in setting GST rates and slabs: The GST Council is the forum for that.) 

This was not a bolt from the blue but part of a longer exercise of rationalising taxes. In this year’s Union Budget, the structure of direct taxes, especially income tax, was overhauled and made friendly for taxpayers. The issues addressed were highlighted in the Economic Survey that precedes the Budget. Under the new tax regime, income taxes have been waived off up to an income of ₹12 lakh. This excludes taxes on special income such as that from capital gains. Some years ago, corporate taxes were rationalised. In 2019-20, companies making fresh investments were given the option to pay 15 per cent tax on such investments. The Minimum Alternate Tax (MAT) was waived off for such companies. For other companies, the rate of taxation was pegged at 22 per cent and MAT was also rationalised. 

These tax rationalisations have spanned seven to eight years and have been thought through. They were a response, in part, of the weakness in consumption demand that has persisted for almost 12-13 years now. This is a problem that cannot be solved by a magic wand and has implications for the entire Indian economy: from investment decisions by companies to consumption choices by consumers. Sequencing of changes to ensure that the economic growth gets a boost from tax rationalisations is an important consideration for the government. In the short-run, the tools available to the government include the right combination of fiscal and monetary policies. This is over and above public investment levers that are under the government’s control.  

From 2020 until 2024-25, the Centre has devoted extraordinary sums for capital expenditure. But there is an upper limit—both in economic terms and constitutionally—on what the it can spend on this score to boost growth. Those limits were apparent even two years ago. At that point, it was evident that a shift of gears from investment to boosting consumption was necessary. The use of taxes—a part of the fiscal toolbox—was just a matter of time. These changes finally kicked in over the past seven to eight months. The latest changes are, in effect, a stimulus to the Indian economy. But because the tool used is a change in the tax system and not outright spending by the government, the risk of corruption and the benefits not reaching their intended beneficiaries will be minimal. 

There is plenty to commend the changes that have been made. Over time, the effective rate of GST has come down substantially. One set of calculations (made by economists Prachi Mishra and Shohan Mukherjee) peg it at 11.43 per cent (down from 11.64 per cent). Another calculation, by economist Neelkanth Mishra, estimates the effective rate at 10.3 per cent, down from 12.6 per cent in November 2017, just months after GST was rolled out on July 1, 2017. This downward trajectory has continued even as states have continued to spar with the Centre over a number of issues.    

This continuous reduction in effective rates, coupled with simplification of the structure of GST, is bound to give much-needed respite to businesses. When GST was introduced in 2017, it was on the basis of a complicated compromise between states and the Centre. The former had been promised 14 per cent growth in GST revenue. This was to ensure that they signed on the dotted line. The terms were generous, perhaps too generous. Over time, the use of GST compensation cess to make good the shortfall in revenue became a bone of contention.

There is an added impetus to the GST reforms. Since April 1, when he announced a slew of tariffs on different countries—the “Liberation Day” tariffs—US President Donald Trump has imposed punitive tariffs of 50 per cent on all Indian imports into the US in two waves. These have cast a shadow over the Indian economy. From initial estimates of a dent of around 0.3 percentage points to GDP growth to the current estimates that range from 0.5 to 0.6 percentage points, it had become necessary for the government to anchor expectations about growth.  

Modern growth is more complicated than the much simpler process in Adam Smith’s day. Any uncertainty quickly affects a number of economic variables such as investment, consumption and inflation. During the Covid-19 pandemic, household savings—which were largely precautionary—witnessed a sudden jump in India. Consumers were deeply uncertain about their economic (and health) prospects and chose to save money. Something similar is happening, albeit at the level of manufacturers and traders across the world. This, in turn, is affecting incomes of individuals involved in sectors as varied as textiles, shrimp farming and manufactures. 

The reforms and reduction in GST rates are sure to provide economic ballast in these uncertain times. Though the finance minister has denied any overt linkage between the changes in GST and the wayward and punitive tariffs imposed on India, the effect of changes in GST is certain to prove a stabilising hand for the Indian economy.   

Donald TrumpGeoeconomyGST reformIndian economyIndian growth storyNirmala Sitharamantrade tariff