Will inflation moderate?

GST Council does well, but questions remain

The Goods and Services Tax (GST) Council, the apex decision-making body for the new federal indirect tax system, held a two-day summit meeting in Srinagar, at which most tax rates under the new regime were decided. A few particularly contentious items, including gold and textiles, were postponed to another meeting to be held in early June. Time is short, as the government has determined the GST will be rolled out starting July 1, and it is therefore welcome that so much progress has been made. For the first time, there is some understanding of the burden of the new tax.

The most crucial macro-economic question that needed to be answered was the impact of the GST on prices, the headline inflation rate — and thus on the Reserve Bank of India’s future decision-making regarding interest rates. As several senior officials have pointed out, although many services will see an increase in tax incidence from 15 per cent to 18 per cent, it is also true that the ability to receive credit against expenses on goods consumed in the provision of those services will — in theory — reduce the effective tax rate on service providers. Thus, any inflationary effect of increased rates will be moderated. Also playing a role in how the GST will pan out is the composition of the consumer price index, or CPI, the variable that the RBI now targets when setting monetary policy. Under the freshly decided tax rates, many major components of the CPI will receive tax exemption or see their rates reduced. For example, foodgrain, cereals, and milk are exempt from the GST; currently several states have levies on foodgrain. Sugar, tea, and edible oil will be taxed at only 5 per cent. Overall, it appears that this set of tax rates has been chosen with a view to ensuring that the effect on headline inflation will be benign. In fact, many now hope the GST will in fact reduce inflation in the short to medium term; a secretary in the finance ministry has suggested it may even go down by 2 percentage points, though it is not clear precisely how. It was previously feared that the GST would instead increase consumer price inflation in the adjustment period. If the effect on prices is indeed benign, then there will be space for the RBI to revisit its assumptions about the future path of inflation, and thus to re-examine its current monetary policy stance.

That said, the possibility of a benign macro-economic effect has been bought at a high price. While the GST Council deserves praise for clubbing a majority of the items within the 12 per cent and 18 per cent slabs, the five-tiered tax structure (when the exempt items are included) is too complex, and can lead to litigation and implementation problems. For services in particular, multiple tax rates for similar services — sometimes being provided by the same organisation — will be a compliance nightmare, and give excessive discretionary powers to the taxman to question returns. The government will have to work swiftly to iron out these implementation questions, and to ensure the GST Network is ready for a July 1 roll-out. Meanwhile, the focus now shifts to industry, which has just a few short weeks to prepare for this comprehensive change in taxation.