GST Rate Cuts and Simplification Must Go Hand in Hand

A multi-layered Goods and Services Tax slab always has the unintended consequence of dampening consumption and negatively impacting businesses. Hence, it is no surprise that Prime Minister Narendra Modi's Independence Day announcement of a proposal on GST reforms has been welcomed by people and industry alike.

India currently has four main slabs 5%, 12%, 18%, and 28% that is proposed to be reduced to a simplified two-tier system of 5% and 18%. There will be another special tax rate for 'sin' goods, which is in place currently too. Many developed countries, such as Australia, Canada, New Zealand, and Japan, have a single GST rate, typically ranging between 5% and 15%. 

To begin with, reforms in the GST framework will bring down taxes on items of daily consumption as they are likely to move from 12% to 5% bracket. Prices of most items such as textiles and apparel, agricultural machinery, automotive components, healthcare and insurance products, and fast-moving consumer goods and retail sectors are also likely to come down.

A lower GST rate will also have a multiplier effect because of reduced logistic costs and simplified compliance. As most items under consideration are price elastic, lower prices due to reduced GST rates will increase demand and create employment. More importantly, when Trump's tariffs are creating disruptions in global trade, it will make India’s exports more competitive. 

For example, let us examine the impact of reduced GST rates on two important sectors, namely textiles and automotive components. India is not only the largest producer of cotton in the world, but also the textile and apparel industry is an industry of national importance when it comes to job creation and exports. This industry employs around 40 million people. 

Currently, in India, apparel items below Rs 1,000 attract a GST of 5%. For apparel items exceeding Rs 1,000, the GST rate is 12%. While there is no GST on export items and exporters also get back taxes paid on inputs there are other complexities.  

Also,  manufacturers in the textile industry need to invest in value-added services such as marketing, warehouse rentals, logistics, courier, and other product fulfilment costs. However, these additional activities attract a GST rate of 18%. This is like the inverted duty structure, as the tax on input is higher than the tax on final output.

The table below demonstrates how a higher GST rate can increase prices by up to 4.4%. The result is the same whether we consider apparel products less than Rs 1,000 (5% GST) and/or more than Rs 1,000 (12% GST).

Costs of goods sold is how much it costs to produce goods and include direct material and labor expenses that go into production of each apparel. The costs do not include indirect costs such as overhead and marketing costs. For the apparel products, the higher GST rate of 18% as opposed to 5% on value added services have an effect on increasing the net sale price by 4.4%. For example, the apparel product priced at ₹1,200, the corresponding figures for tax payment are ₹66, with 18% GST and ₹47, with 5% GST, respectively.

Additionally, the apparel industry that is into exports also suffers from the issues related to refund of input tax credit. Since, March 2019, the government introduced Rebate of State and Central Taxes and Levies to refund the input tax. However, apparel industry owners still complain of an inability to get back this refund on account of lack of coordination between the Ministry of Finance and Ministry of Textiles.

When combining interest costs, delayed payments, and costs of goods sold, a higher GST rate of 18% translates to an additional cost of 8%, which will certainly make our apparel items uncompetitive.

The story is the same for manufacturers of aluminium automotive components. The government of India has protected the raw aluminium industry by imposing a custom duty in excess of 7.5%. If one were to add the ad valorem and special duties, the figure goes beyond 10%, which makes Indian manufacturers producing final aluminum products such as automotive components and agricultural machinery less competitive in the global market.

Additionally, the GST rate on aluminium automotive products is 28%, which is the highest GST slab rate. The high GST structure lowers the trade margin for the makers of aluminium automotive product. This makes the business unsustainable even in the domestic market. For example, Chinese government give 16% subsidy to manufacturers of final aluminium automotive products making the Chinese firms competitive in the world market. 

Therefore, the reforms in the GST framework are certainly a welcome move. Even for sectors such as insurance, this will bring down the cost of insurance products. India has a large section of the population, almost 400 million, is uninsured and has to depend on out-of-pocket expenses for medical treatment. Most lower and middle-income households will also get respite as prices of FMCG items are going to come down. True to form, the GST reforms can be touted as a Diwali gift for the nation.