GST rates and manufacturing growth
The government, with the approval of the Goods and Services Tax (GST) Council, has constituted a group of ministers under the leadership of Karnataka chief minister to make suggestions on GST rate rationalisation. The attempt is to balance the twin objectives of ensuring revenue neutrality (pre-gst levels) while also maintaining industrial competitiveness.
The robust design of the GST is based on ensuring that the entire value chain from raw material to retail is brought under the GST net. This would ensure that there is no cascading effect of tax on tax and only the value addition at each stage is taxed. This design requires that there be no exemptions because any exemption breaks the pass through of the taxes and creates the problem of embedded taxes at various points in the value chain, increasing costs. While the importance of phasing out exemptions is commonly accepted, there is insufficient awareness of low rates of duty causing an inverted duty structure and accumulation of input tax credits at various points in the value chain.
It is therefore important to understand the universe of GST paying inputs. This universe of input can be split into three parts, namely input goods, input services and capital goods. The capital goods component is very important for taxes as it can create accumulation of credits if the output goods are not appropriately taxed at a level at which it can offset the earlier taxes. Therefore, ideally, to attract fresh investment as visualised in the productivity-linked incentive (PLI) scheme to boost manufacturing, the output GST rate for the manufacturing sector must be closer to the standard rate.
In fixing the GST rates, it may be appropriate to merge the 12 per cent and the 18 per cent GST rate to a standard 16 per cent and not raise the 18 per cent to 20 per cent as is being talked about. This would also bring down the standard GST rate on services and reduce inflationary pressure. A low standard rate would also require that the merit rate be raised to reduce the gap between standard and the merit rate. This could be raised from the current 5 per cent to 8 per cent.
The current clamour for a lower GST rate by various manufacturing industries is based on a narrow focus on the taxes on input goods, and ignores considerable taxes that are also embedded in input services and capital goods. The capital goods component is especially important now in view of the mandated guidelines for installation of pollution control equipment.
Further, a lower GST rate would also hurt the manufacturing segment wanting to avail the PLI scheme benefits where substantial investment would entail taxes on capital equipment, which for offsetting would require reasonable output GST rates. As manufacturing units move up the value chain, input services like design, intellectual property rights, financial services become more and more important. Therefore, the manufacturing sector must desist from embracing shorttermism but look at these rates from the medium/long term perspective of growth and modernisation.
Unfortunately, the total input taxes cannot be easily segmented into three components because of data issues. This can be done through some proxy assumptions. The short point is that if substantial investment is to take place in manufacturing, the GST rates cannot be low, as it would create accumulated tax credits, which will raise project costs and disincentivise investors.
In addition to an appropriate GST structure, manufacturing growth would also require a low import tariff regime covering critical raw materials and capital equipment not manufactured in India. These rates now averaging between 15 per cent and 18 per cent are too high, and hurt the manufacturing sector.
During the recent Covid crisis, despite having a robust domestic vaccine industry, production depended on import of critical raw materials like filter bags from the United States. Complete selfsufficiency is therefore not feasible but should be confined to a few critical sectors as the PLI scheme has sought to do.
Needless to mention, tax policy is not the only factor that will influence investment decisions. To create a favourable ecosystem for manufacturing growth, one needs to reform the factor markets, which includes land, labour and energy.
In the GST rate debate, therefore, rate fixation has to look at the input supply chain in its entirety. One of the reasons why GST rate fixation evokes a strong reaction is that there is an asymmetry of information between the government, on the one hand, and trade and industries on the other. It is therefore important to share information in the public domain and acquaint all the stakeholders with the relevant facts. Communication is vital. Reform by stealth is not feasible and also not desirable. Reform has to be based on widespread consultation and debate. This is especially important in the case of economic reforms where issues are more complex and nuanced with both pros and cons and then there is a resultant. It is not easy to explain the overall advantage of the resultant and requires policy mandarins to have both domain knowledge and the gift of communication. Many years ago, Francis Bacon famously remarked that “Knowledge is power”. Today in a digital world where public participation and awareness is intense, “expression is also power”.