Is GST connected to equity taxation?

A revenue building measure is badly needed by the fiscally constrained government in a pre-election year where GST collections are running significantly below the expected trend

Alot has been said about whether capital gains taxes on equities will be raised in the upcoming Budget. The common response from the fund management community has been “unlikely, because Mr Modi doesn’t want to create one more big disruption before election and the government wouldn’t get much out of it anyway”. Without going into the politics or rationality of the potential tax increase, let us focus on the latter part of it. How much can the government get out of it? Our analysis suggests that this number could be as big as ~300-500 bn (US$4.5-8 bn). This is a meaningfully large number for the government to consider as a revenue building measure. Is a revenue building measure really needed by the government? It can be argued that this is badly needed for the fiscally constrained government in a pre-election year where GST collections are running significantly below the expected trend and our calculations suggest that GST collection shortfall will be even bigger than FY19, to the tune of nearly ~1.5 trillion (US$23 bn) or almost 90 bps of GDP.

Let’s take a look why GST revenue shortfall will be such a big number in FY19 and why it is not visible in FY18 itself. The primary reason is that the GST system results in upfronting of tax payment as compared to the previous regime. The IGST (50 per cent of the total GST collections) part of the GST is applicable to inter- state trade/movement of goods/services and also on imports. In the case of inter-state movement of goods between company depots, even though the goods are not “sold”, IGST is levied. The same applies to imports. As soon as goods are imported into the country, IGST is levied aside from the customs duties. One might argue that excise duties or countervailing duties were also levied in a similar manner earlier but the point to keep in mind is that GST rates are higher than excise duty rates and subsume VAT also. There was no upfronting of VAT in the earlier regime. A secondary reason is, in the run up to the implementation of the GST, several businesses had reduced the inventories and a lot of those inventories are getting rebuilt post July. And hence, a part of IGST collections is associated with this inventory build-up and unsustainable.

In simpler words, FY18 GST collections include some portion of taxes that would have been recognised as revenues for FY19 under the earlier regime. Also inventory building after GST implementation in June 2017 has further inflated GST collection numbers. This unsustainable portion of collections in FY18 is the ‘IGST float’. The estimated IGST float for FY18 would be about ~1.5 trillion (US$23 bn). According to the data released by the government for July-November 2017, that is, for five months, this IGST float is already ~1.4 trillion. While this IGST float would sustain, the IGST float ‘income’ should fall by 90 per cent YoY in FY19, creating a big revenue shortfall for the government in FY19.

The key question here is, why is the sustainable rate of GST collections significantly lower than the expected number. There are four possibilities. 1. The economy slowed down meaningfully. 2. Tax compliance has gone down. 3. GST rates are lower than the effective tax rates visà-vis earlier regime. 4. IGST settlement number is understated due to systemic issues and the real IGST float is much smaller and the sustainable rate of tax collections is not as bad as it appears to be.

The last one is the most bullish possibility and then we need not worry about FY19 GST collections so much. No. 1 should be ruled out looking at the various economic indicators. My base case is some combination of No. 2 and 3. Tax compliance has possibly weakened because the government has suspended three of the most potent aspects of the GST: invoice matching mechanism, reverse charge mechanism and e-way bill. Tax compliance will likely remain weak till these three aspects of the GST are resumed. The situation as per No. 3 could be due to the underestimation of the negative impact of input tax credit. Please note that in the previous regime, the extent of input tax credit was quite limited, now businesses can claim input tax credit on virtually each and every expense item, whether spurious or real.

The best case, however, is that the government would reinstate the compliance improvement measures as soon as possible thereby driving a big increase in the sustainable rate of GST collections in FY19 but that might be a politically sensitive issue. The government might need to weigh the political sensitivity of these compliance enhancement measures vis-à-vis the raising of equity taxation. The latter appears like an easier option. We don’t have to wait for too long to know which way the government will go.