How India’s Tax Reform Is A Major Economic Boon (PIN)

From Invesco: On July 1, 2017, India ushered in its largest-ever indirect tax reform — the rollout of the Goods and Services Tax (GST) bill.

The GST replaced 16 different types of state and federal taxes with one common tax system, comprising four major tax rates (5%, 12%, 18% and 28%) and a few other special categories for specified items. The bill is intended to simplify the taxation structure and be tax-neutral, by charging at the rates of the goods and services close to the existing rates.

Major tax categories

What we think…

Our team believes this is a game-changing development that will bring structural benefits to the Indian economy. In fact, the government has made an effort to “make it happen” by rolling out the GST on July 1, 2017, without delay, following the GST bill passage by both houses of the Parliament one year ago. The GST is an encouraging tax framework that has further room for enhancement going forward. We believe the rollout of the GST is a long-term positive for consumers, business owners and the government in India, creating a win-win situation for all economic stakeholders.

Benefits to consumers: Overall tax burden to come down

The immediate benefit for consumers is the elimination of the “tax on tax” issue. Prior to the GST rollout, goods were taxed multiple times at different rates during the production process. The GST will subsume many of these taxes into one common tax regime and will tax goods and services only at the point of consumption, rather than the point of production. Credits of input taxes paid at each production stage are available in the subsequent stage of value addition, which makes the GST essentially a tax on value addition at each stage only. The consumer bears only the GST charged by the last dealer in the supply chain.

In this way, the GST system essentially will create efficiency gains along the value chain, as the overall tax burden on most goods and services should eventually come down, ultimately benefiting consumers. To ensure effective implementation, the GST bill also contains an “anti-profiteering clause” that will help ensure any tax reduction (as a result of GST implementation) will be fully passed on to consumers.

Benefits to corporations: Significant logistical benefits by removing trade barriers and improving ease of doing business

For corporations, there was previously a 2% Central Sales Tax (CST) levied on the flow of goods going through different states. A simple product, such as a toothbrush, could be subject to one set of taxes in one state and another set of taxes when passing through a different state. Any goods going through different states could take weeks to clear through taxmen before arriving in the hands of the final consumers.

The rollout of the GST subsumes the CST; thus, no interstate tax will be levied during the trading process. This will significantly minimize delays and boost logistical efficiency. Fewer but larger warehouses would be needed, which should bring down operating costs and result in better working capital management for corporations. Lastly, with the removal of tax disparity across different states, the ease of doing business should be improved.

Benefits to government: Boosting fiscal revenue

The tax-to-GDP (gross domestic product) ratio in India is significantly lower than the average of 34% for countries in the Organization for Economic Cooperation and Development.¹ The GST regime requires buyers and sellers to match their invoices, which will make it quite difficult to evade taxes, especially in the context of business-to-business transactions. We believe this should improve overall tax compliance, and the tax-to-GDP ratio could go up. An increase in tax revenue collection would boost the fiscal strength of India and help ease the fiscal deficit.

Moving India toward a ‘formal’ economy

The Indian economy is an “informal” one, as many businesses in India (especially small enterprises) do not disclose taxable incomes and are therefore easily able to hide outside of the government’s tax net. The GST rollout will bring a large amount of the economy back into the tax net as corporations would now need to claim tax credits accumulated at previous stages of goods production to reduce the amount of taxes they pay.

Looking ahead, we believe sectors that have high share of “unorganized” players — i.e., unbranded, small-scale enterprises that have low cost structures and are not tax-compliant — will face consolidation. Currently, there are many such players in different consumer-related segments. Examples include the footwear sector, in which 60% to 70% of the companies are unorganized, and the ceramics sector, in which about 50% of the companies are unorganized.² As the Indian economy moves toward formalization, there will be value migration from unorganized to organized players. We expect branded companies in organized sectors to gain market share amid this economic transition.

Further GST enhancements ahead

The government’s intention is to roll out the GST first, followed by enhancements in gradual steps. It is not a perfect scheme, but it presents a very decent framework to start with. We expect temporary disruption of businesses around the time of the GST rollout. For example, business-to-consumer retail channels had to de-stock their inventories before July 1, given that the government may not be able to compensate them fully on the excise duty tax component on closing. Also, certain areas that were exempted from the GST — such as petroleum, real-estate land and health — may not be able to pass through costs because they do not benefit from tax credits across the value chain.

We expect any business disruptions during the rollout will prove to be transient in nature and that the hiccups in implementation will eventually be resolved over the next one to two quarters. Nevertheless, the tremendous benefits brought by the long-awaited GST scheme are structural, paving the way for sustainable economic growth in India.

The PowerShares India Portfolio ETF (NYSE:PIN) was unchanged in premarket trading Friday. Year-to-date, PIN has gained 19.71%, versus a 7.61% rise in the benchmark S&P 500 index during the same period.

PIN currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #26 of 76 ETFs in the Asia Pacific Equities Ex-China ETFs category.

1 Source: Thehansindia.com, as of January 2017. Data for fiscal year 2015-2016.
2 Source: Kotak Institutional Research, as of June 2017

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This article is brought to you courtesy of Invesco.

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