Can India Inc Survive The Goods & Services Tax?

by: Shiv Kapoor

GST's beauty lies in simplicity.

India's GST is complex by design.

Multiple rates and no coverage of several areas of the economy is bad.

But the worst risk arises from GST input tax credit mechanism.

For those of you who have bought into Indian ETF's such as the iShares MSCI India Index ETF (INDA), WisdomTree India Earnings ETF (NYSEARCA:EPI), or VanEck Vectors India Small-Cap Index ETF (NYSEARCA:SCIF), you have likely had a good run - the Indian markets have been strong, and returns in USD terms have been stronger as a consequence of the stronger Indian currency. Much of these gains have been driven by high growth expectations. And those growth expectations have been driven in no small part by the Goods & Services tax which is soon to come into force in India. The Goods & Services tax is perhaps Indian's most major tax reform in all time - you can follow the excitement in India here. This tax will replace a host of indirect state taxes and the national service tax. The new single tax should usher in a period of vastly improved ease of doing business in India. In addition, introduction of this law facilitates cross state border movement of goods and services, which will serve to boost inter state commerce thus driving higher growth. It will also have a big influence on allocating national resources more efficiently. It could truly be a game changer for India. But now, the big event being anticipated is on the verge of occurrence, and prices have moved in advance of the benefits of accelerated growth - it is time to pause and re-evaluate growth expectations.

I'm bearish on India because animal spirits have pushed price too far. Valuations are unattractive as a consequence. Growth expectations are high, but in my view the confidence is misplaced. What makes me despondent about growth expectations?

The stress from bad debts within the financial services sector remains elevated, making credit growth, and as a consequence economic growth, challenging. The two big export sectors (information technology and pharmaceuticals) which drive domestic demand in no small way are also facing challenging times. Several in the material and mining industry continue to be challenged by embarrassing capital structures. India has also seen no real earnings growth for over five years now.

Normally, when nothing is working as it should, I get bullish. But once the price action has worked its magic, its time to get real about growth expectations. At this point in time my biggest fear is the goods and services tax, expected to come into force on 1st July, 2017. As it happens, this event is a significant cause of optimism in the Indian market. So why am I worried?

India has this ability to over complicate the simplest tasks and thus snatch defeat from the jaws of victory! The beauty of GST lies in its simplicity. But ours is complex by design.

Instead of ensuring that GST covers virtually all goods and services, we have not covered a major part of the economy - energy. Yet, we will not recognize the defects in design, and allow fair tax credits for other indirect taxes paid by excluded sectors like energy. Instead, we make their lives impossible - they will continue to pay and expense several indirect taxes, and will have problems with recovery or credit for GST paid to their many covered suppliers. In all likelihood they shall end up worse than before.

Instead of adopting a couple of applicable rates, we have several different rates applicable to different goods and services. This eliminates simplicity in law to a great extent. And it also opens the door to future litigation arising due to different interpretations of law in respect of the applicable rate.

All of this is challenging. But we can get around it by hiring two, where one ought to be adequate. It won't help ease of doing business, but it might help with the present absence of job creation!

But there is one other complexity which must be introduced to lower the chance of success. In India's situation, we run the risk of financial contagion spreading through the entire value chain as a consequence of a poorly designed input tax credit mechanism. This is dangerous in an economy already suffering from high levels of financial stress. And it is made worse by a poor culture of compliance.

Essentially, by allowing a credit for input GST only after validating that the supplier has settled the GST by payment or offset, the compliance burden shifts from the government to the tax payer. Ask yourself this - why must my business suffer because of the governments inability to enforce laws and collect GST that I have paid to my supplier, who has, in turn, not paid it to the government? Financially weak and non complaint companies lower in the supply chain, can export the contagion through the supply chain and cause major economic turmoil.

End user taxes the world over are built on the philosophy that the goods/service provider acts as a collection agent for the government - they charge and collect GST from their customers, and reduce the amount that they have paid in GST to their suppliers from that amount. They then pass the net amount through to the government. The burden of GST always lies with the end user alone. The entire supply chain is merely acting as an agent of the government, collecting and passing through components of the end user tax to the government at each point of value addition.

If one goods/service provider does not discharge its obligation, the taxing authority must enforce its right to collect against the truant party. By disallowing the recipient of goods or services a tax credit due to non payment by a truant party lower in the value chain, the burden of non compliance has shifted to the goods/service recipient, from the government where it rightly belongs. What more, it is encouraging the compliant tax payer to turn truant as a consequence of unfairness in the system towards compliant tax payers!

In many ways this is similar to a situation where income tax is deducted at source, but the withheld income tax, is not paid by a truant deductor to the government. The poor compliant tax payer is denied a tax credit and risks having to pay the tax two times - once by withholding by the truant deductor, and once directly to the government on denial of a tax credit. Why? After all the government has the right to collect the TDS, penalty, and interest from the truant deductor and they must do it - tax administrations should do their job or get out of the way - collecting tax from truant taxpayers is their job, not mine.

Sadly, in our system, it is the compliant tax payer who always suffers. In many ways, this encourages the culture of non compliance in India.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.