Investors rarely welcome the imposition of new taxes, but they’re happy to make an exception for India. On September 8, President Pranab Mukherjee signed the Goods and Services Tax Bill after 16 states, a majority, ratified the legislation this summer.
The GST, a common national tax that will replace a patchwork of central and state government sales and excise levies, is the most significant economic reform achievement of the government of Prime Minister Narendra Modi. The measure promises to simplify and streamline the country’s chaotic tax system and turn a Balkanized economy into a genuine single market, stimulating investment by both Indian companies and foreign investors. By broadening the tax base, many analysts believe, the GST’s revenues will also strengthen India’s public finances over time, which would give the Reserve Bank of India greater leeway for lowering interest rates.
“It’s an unambiguous long-term economic positive,” says Sasha Riser-Kositsky, an Asia analyst at consultancy Eurasia Group in Washington. The National Council of Applied Economic Research, an independent New Delhi think tank, estimated several years ago that a GST could lift the country’s annual growth rate by 0.9 to 1.7 percentage points. Such a boost would supercharge an economy that the International Monetary Fund predicts will expand by 7.4 percent this year and next, the fastest rate of any major economy in the world.
Imagine if a company transporting goods from California to New York had to have its trucks stop at each state line so that inspectors could assess the contents and tax goods according to that state’s tax laws. This is how it works in India. Trucks idle in innumerable queues, perishables go bad, time is wasted, and bottlenecks form across the country. Mark Vincent, director of global emerging-markets equities at Standard Life Investments in Edinburgh, says that if it takes ten hours to transport goods a certain distance within China, a comparable trip in India could take nearly 60 hours.
“The biggest benefit is a substantial step forward toward improvement in the ease of doing business,” says Prashant Khemka, CIO of global emerging markets equity at Goldman Sachs Asset Management. Any gain would be welcome. India currently ranks a lowly 130th out of 189 countries, according to the World Bank’s Doing Business 2016 report. (China ranks 84th; the U.S. is No. 7.) “This is not surprising if you’ve lived in India and suffered through the regulatory complexity,” says Khemka. “A lot of very productive people spend their time resolving tax-related headaches, rather than focusing on growing businesses, increasing productivity or competing in local and export markets.”
“GST is all about productivity,” says Michael Kelly, global head of multiasset and manager selection at PineBridge Investments in New York. Part of Kelly’s strategy has been to consider the effects of similar taxes in other developing markets, such as Malaysia, which adopted its own GST in 2015. “Over five years, growth tends to pick up, and inflation tends to drop down,” he says. “That’s music to the ears of an international investor.” Modi has set a target date of April 1, 2017, the start of the next fiscal year, for the tax to go into effect, but Kelly predicts that Indian equities won’t benefit for another year or so, as it takes time for the new regime to spur investment and growth.
The government still has much to do to meet that April target date. A GST Council, chaired by Finance minister Arun Jaitley and including finance ministers from India’s 29 states, must set the tax rates to be applied under the new system, agree on any exemptions and create a mechanism for resolving disputes between different levels of government. The system will have a standard rate covering most goods and services, a reduced rate covering essential goods and a higher rate for luxury goods. Recent reports have suggested that the standard rate could be set somewhere between 16 and 20 percent. Some states have been pressing for the rate to be set relatively high, to ensure they don’t lose out when it comes to sharing the revenues generated by the tax, but Jaitley has said the government will aim to set a revenue-neutral rate. There’s no easy comparison to India’s current state and central tax rates. However, the new system will include deductions for certain business-related expenses that could allow some companies to pay less tax than they do currently. Meanwhile, Infosys is developing a dedicated IT system to process taxes under the new regime.
Parliament needs to endorse any GST deal and is due to consider enabling legislation in the winter session that begins in November, but speedy approval is hardly guaranteed. The GST was first proposed a decade ago by the Indian National Congress–led government of then prime minister Manmohan Singh, and it has taken Modi’s Bharatiya Janata Party nearly two years to get the tax this close to the finishing line.
“If we do have implementation on the first of April, that will certainly be a market-moving event,” says Kumaran Damodaran, emerging-markets debt portfolio manager at Stone Harbor Investment Partners in London. The biggest advantage Damodaran sees is the potential for the GST to clean up fiscal policy. In March, Jaitley presented a budget in Parliament that aims to reduce the deficit to 3.5 percent of GDP in the current fiscal year, which ends next March 31, from 3.9 percent last year. A narrower deficit could help bring interest rates down, analysts say. In April the central bank reduced its policy rate by 25 basis points, to 6.5 percent, a five-year low.
The GST will go a long way toward facilitating India’s internal trade, which accounts for some 11 percent of gross domestic product, according to the World Bank. It should also bring some of the country’s large, informal economy out into the open, analysts say. “Cash transactions are going to be increasingly difficult in the GST world,” says Standard Life Investments’ Vincent.
Entrepreneurs who run small and medium-size businesses will benefit the most, analysts say. The simplicity of the new tax system will free up time and energy to enable them to grow their operations and become more competitive. Larger companies, which currently pay the bulk of corporate taxes, also stand to gain as the new regime forces more people out of the black economy and broadens the tax base. Everyone stands to win, investors included. “A difficult environment for doing business is the single biggest reason India is not a much bigger economy than it is today,” says Goldman Sachs’ Khemka.
