GST to push up inflation in the short term

While the finance ministry has sought to allay fears that the implementation of the goods and services tax (GST) will have an impact on inflation, analysts remain sceptical.

"Implementation of the GST in the near term could bring some upturn in inflation," said Morgan Stanley in a report. Assuming a revenue neutral rate (RNR) of 15 per cent, with a lower rate of 12 per cent for some items and a standard rate of 22 per cent for others, Morgan Stanley estimates that the shift to the new indirect tax architecture could have a 0.3 to 0.7 percentage point impact on inflation. HSBC Global Research estimates that if the GST rate is kept at 18 per cent, then Consumer Price Index (CPI) would rise by 20 basis points (bps). But if the RNR is kept higher, at 22 per cent, then inflation could rise by 70 bps.

However, both reports acknowledge that this increase in inflation would be a temporary phenomenon. Over the medium-term, inflation would tend to be structurally lower because of a reduction in logistic costs, streamlining of production and efficiency gains. But despite the long-term impact, higher inflation in the short-term could limit Reserve Bank of India's (RBI) room to cut interest rates. If inflation were to remain at its current level, it rose to 5.77 per cent in June, any increase due to the implementation of GST would bring it perilously close to RBI's six per cent target.

But others aren't so sure about the impact on inflation. According to Marie Diron, senior vice-president, Sovereign Risk Group, Moody's Investors Service, "GST will have no significant impact on inflation, in line with the revenue-neutral framework. GST could raise inflation if the cuts to prices from the removal of various taxes that GST will replace are not fully passed on, while the GST is fully reflected in retail prices." Chief Economic Advisor Arvind Subramanian is reported to have said that even if the GST rate is 18-20 per cent, there would be no average impact on inflation. Part of the belief stems from the fact that even while service tax rates will head upwards, the impact on headline inflation will remain limited as a number of items will be kept outside the purview of GST. Responding to questions raised by Opposition leaders in the Rajya Sabha, Finance Minister Arun Jaitley had elaborated that 54 per cent of items in CPI will be exempted from GST, while 32 per cent will attract lower rates.

While more clarity will emerge once the RNR is decided and the product categories, which will attract different rates are finalised, a look at the experience of other countries that shifted to GST does show a spike in inflation during the short term.