A fog descends on a house under renovation TESSELLATUM
The “weak near term for a strong long-term” view of the Indian economy is now consensus. Structural changes such as millions of workers forced away from agriculture, goods and services tax (GST), Bankruptcy Code implementation and RERA (Real Estate Regulatory Authority) disrupt age-old business norms, drive a much-needed and delayed systemic clean-up, and establish new, more efficient rules. Parallels to a house under renovation are now clearly visible: The noise and dust, the absence of usual comforts, and the not infrequent worry if all this discomfort will be worth it and things will indeed normalise.
Investors and voters alike appear willing to live through the near-term pain (or lack options). Weak demand growth for widely consumed commodities such as oil, cement and power, multi-decade lows for loan growth, and sharp downward revisions to gross domestic product (GDP) and earnings estimates for this year have not driven any meaningful market correction. Projections for the next financial year remain optimistic even as economic vitality seems limited to a few pockets such as automobile sales and airline traffic.
The deeper question of course is how long the disruption lasts: A slowdown that lasts a few years (and we are already well over a year into it) would test this optimism in the long-term. Unfortunately, the visibility on several macroeconomic parameters has worsened, as if a fog has descended. We know very little about growth, fiscal deficits, banking system health, inflation and even the currency.
Let us start with growth. Channel checks and company commentary suggest that the GST is indeed increasing tax compliance, even if the extent is harder to assess. Establishment of the muchneeded link between indirect and direct taxes (as flagged in this column on January 2, Vexing taxing problems, Business Standard) should help, too. Several unintended changes have also been triggered, each of which is desirable, but needs time, and slows down activity. Like a reassessment of long-held mark-ups for wholesalers and retailers, as many realise that current margins may not suffice if all taxes are to be paid. Further, retailers are realising that to get a GST registration they also need to register their shops, but state infrastructure is not prepared to handle the surge in registration requests. In turn, this is exposing inconsistencies such as the mismatch between the number of pharmacists and pharmacies, when each pharmacy is legally required to have a pharmacist.
Compounding this growth uncertainty is a measurement problem: Quarterly GDP growth is little better than a guesstimate to start with, but is likely to get even more distorted for at least four more quarters. A significant part of quarterly GDP was projected on the basis of sales tax and service tax collection data, and those are no longer available because these taxes have been subsumed by the GST. The GST data that becomes available instead is expected to be much more granular, but will take time to stabilise, and to interpret.
On the fiscal side, it will take several months to assess if the GST rates are “revenue neutral”, that is, full year collections would be close to the ~10.6 lakh crore (40 per cent of total taxes) that were estimated for taxes that the GST subsumed. Notwithstanding the attempt to keep tax rates unchanged for most categories, the effective tax rate on most categories has changed. Add to that the expected improvement in compliance, and the near-term economic slowdown, and revenue neutrality becomes nearly impossible to assess. If taxes turn out to be higher, they would act as a fiscal drag, as government(s) cannot ramp up their spending this year to match the revenues. If they are too low (which appears unlikely), it would act as a fiscal stimulus, but drive up the fiscal deficit this year. The GST Council may only revise rates in November or later, and keeping the next fiscal year in mind.
The GST collections for July (~11.1 lakh crore if multiplied by 12) should not be taken as representative. In addition to the likelihood of limited input-tax credit (news reports suggest very few invoices have been uploaded so far – this is needed to claim credit), the re-stocking related distortion (that followed sharp de-stocking in May and June), slower activity levels (that have improved meaningfully in August), and likely pre-dating of sales (to take advantage of lower rates pre-GST), there is the issue of more than half of taxes being reported as the IGST (integrated goods and service tax). A meaningful part of the IGST is likely to be for inventory building, and should not be annualised.
To the growth and fiscal uncertainty add inflation (how much can it rebound? Will higher tax compliance also drive prices higher?), currency (will it continue to appreciate against the US dollar?), banking system health, and how the bankruptcy process evolves. It is hard to expect entrepreneurs to invest amidst such uncertainty. That psychology affects markets, driving bull and bear cycles, is well understood, but economic cycles also get affected by “animal spirits”. Industry utilisation is an important input into investment decisions, but so is the demand outlook. Prolonged uncertainty can be detrimental to growth: The economy may need both monetary and fiscal help.