Diwali tax cuts risk worsening India's tariff sting as Trump threat looms

By Andy Mukherjee

 

Prime Minister Narendra Modi has promised 1.4 billion consumers a big Diwali gift of lower consumption taxes, presumably to soften the blow in case President Donald Trump goes ahead with his threat and doubles tariffs on India this week. But the cure comes with its own headaches.

 

Amazon.com Inc. and Walmart Inc.’s Flipkart will launch their annual shopping festivals a month or more before the Diwali holidays in the third week of October. If buyers postpone their purchases during this crucial period to wait for lower prices, inventories will pile up. The auto industry, which expects to benefit the most from tax reductions, is asking Modi to speed up the cuts.

 

 

That may well happen, though it will also create problems.

 

For one thing, the 28 state governments that agreed eight years ago to forgo many of their local levies to adopt a unified goods and services tax would want clarity on their share of the pie. A rushed implementation of Modi’s so-called “next generation GST reforms” in which New Delhi pushes out most of the burden of lower revenue to states, could backfire.  

 

Stocks have fallen way behind other emerging markets this year, and now fixed-income traders are turning nervous, too. The spread between the 10-year yield and the central bank’s policy rate shot up to a two-year high last week as investors demanded more compensation for holding government bonds. The risk here is not so much of a blowout increase in borrowings in the near term, but the unpredictable consequences of a reboot in economic strategy.

 

The readjustment is not a bad thing in itself. As I wrote in January, the whole mythology of emulating China’s multi-decade investment boom needed a reappraisal in favour of helping ordinary families keep their heads above water. The problem, however, is with the circumstances of the move — and its timing. To investors, Team Modi’s strategy appears to be little more than a kneejerk reaction to Trump’s tariff shock.    

 

Media reports have suggested that the revamped GST will consolidate the plethora of existing rates —  zero, 5 per cent, 12 per cent, 18 per cent, 28 per cent — into fewer brackets. Most of the items of everyday use that fall in the 12 per cent category, such as dairy, juices, snacks, coffee, textiles, and footwear, are expected to move to 5 per cent. The 28 per cent rate on cement, televisions, refrigerators and air-conditioners might ease to 18 per cent. 

 

More expensive cars are currently taxed at 48 per cent. That’s because they attract a 20 per cent additional levy on top of a 28 per cent GST. Carmakers have long complained that this was simply unviable for the industry. It is expected that the whole thing will be replaced by a new all-inclusive rate of 40 per cent. Small cars and motorcycles of up to 350cc may be taxed at 18 per cent. 

 

While lower consumption taxes will indeed spur demand, particularly for durables such as autos, TVs and ACs, it may not happen immediately. These are precisely the industries where trade channels are flush with inventories. As consumers delay spending to wait for lower prices, “dealers may need to offer deeper discounts during the festive season to clear their existing stock, or, depending on market conditions, choose not to pass on the full benefit of the tax cuts to consumers later,” notes Mumbai-based Ambit Capital. September-quarter sales could take a hit.

 

Dodging that bullet will require the GST Council — a joint forum of national and state authorities — to sign off on the reform package at its next meeting on Sept. 3-4. Getting a buy-in shouldn’t prove too difficult, given that the federal government has a third of the voting rights in the council, and Modi’s ruling party is in power in enough states to get its desired outcome. But even if political opposition doesn’t get in the way, economic forces might intervene. 

 

Chalk it up to the strange nature of Trump’s punishment. The American president keeps threatening Russia with “massive sanctions” unless it agrees to end the war in Ukraine. But so far there’s no sign of a further financial squeeze on Moscow. Nor has Washington taken any measures yet against those it holds directly responsible for stuffing Vladimir Putin’s war chest. US Treasury Secretary Scott Bessent says “some of the richest families in India” have profiteered — to the tune of $16 billion from the oil trade.

 

Yet, pending a last-minute deal, it’s the shrimp farmers in Kerala, textile workers in Tamil Nadu, and diamond cutters and polishers in Gujarat who will be hurt the most as an already prohibitive tariff of 25 per cent rises to 50 per cent. The US customs department has put up a notice of the additional duty that will come into force from 12:01 a.m. Eastern Time on Aug. 27.

 

The Modi government is pushing the states to help their exporting industries to minimise job losses. At the same time, states may end up shouldering nearly two-thirds of the burden from lower GST rates, according to Ambit Research.

 

If local governments hit the brakes on their capital spending, much of the expected benefits of the stimulus — including a $12 billion reduction in personal taxes in the February budget — may be lost.   

 

For a lower-middle-income country plagued by extreme inequality, it’s simply impossible to deliver sustainable growth powered by local demand. But Trump has put paid to India’s ambition to take over from China as the world’s next factory. If your largest export destination is going to sanction your products, there’s no other option except to prime the fiscal pump with Diwali gifts. The markets can sense the desperation.    (Disclaimer: This is a Bloomberg Opinion piece, and these are the personal opinions of the writer. They do not reflect the views of www.business-standard.com or the Business Standard newspaper)