Let’s Not Forget Murphy’s Law!

Steven Philip Warner | The Dollar Business

There’s always an upside to a downside. Think of the two most popular three-letter words that were symbolic of a prelude to victory for India on the global stage last month – Rio and GST. While we missed the gold at Rio by many miles, at many-an-event, it has given us golden hope for a better than yesterday face-off in Tokyo four years later. [I’m more excited about how an Abenomics-driven nation can handle the expensive weight of an Olympics.] And despite prevailing uncertainties over GST (Goods and Services Tax) – rates, deadlines, laws, etc. – progress made in the passage of this tax reform makes us believe that we’re ultimately living in a nation where the opposition party doesn’t necessarily oppose everything that’s good for the nation. Away from sports and politics, passage of the GST (Constitution Amendment) Bill in the Upper House early last month, literally marks the revival of a dormant controversy, one that’s apparently good news for India’s manufacturing and export communities. But remember, everything “most exciting” can also be everything “most unpredictable”. With GST, it may be no different. Murphy’s Law, let me remind you.

GST is talked about as being a potential game changer. There is little doubt that GST will mark the move towards creation of a common Indian market for manufacturers and sellers alike, and nullify the cascading effect of tax on the cost of goods and services. From tax structure to tax credit utilisation and impact on buyers – GST in the form as it is being imagined is set to overhaul the existing indirect tax system in India. From the viewpoint of the services and manufacturing exports community, the impact of GST is to be understood in two aspects. One, its effect on the factors of production. Two, its effect on exports.

With Central taxes (like Excise duty, CST, Service tax, ACD, Additional excise duty, etc.) and State-level taxes like (VAT, Entertainment tax, Entry tax, Octroi, Luxury tax, etc.) being subsumed under GST, you’ll find companies settling on altered strategies for sourcing and distribution. And along with the changed tax rates, the new arrangements will impact both their pricing, profitability and cash flows. Suddenly, inter-State procurement will look viable, tax savings due to GST rates will call for repricing of products, removal of excise duty on manufacturing would mean revised distribution strategies and perhaps even superior cash flows and lower inventory costs (due to GST being paid at the final point of sale), etc. It all sounds good when looked at from the taxation point of view. It all appears forward-moving for both production and exports. But unpredictable it can get.

As this issue was being sent to print (on August 22, 2016), only three states (Assam, Bihar and Jharkhand) had ratified the Bill. 13 more State assemblies were yet to give their nod. After that happens, the President has to approve the bill, post which the GST Council will be constituted and assist the Finance Ministry in drafting the Central GST (CGST), State GST (SGST) and Integrated GST (IGST) Bills. These three bills will then be tabled in the winter session of the Parliament. There are matters still undecided about the three bills. Two questions. One, when will GST go live? [Even if the government gets a minimum of 16 States to agree to the GST Constitution amendment bill by September 10, drafts the CGST, IGST and SGST bills in time for the Winter session, gets all State assemblies to say “AYES” to the SGST bill, is April 2017 enough time for the nation to have the GST in all three forms rolled out? Recall the Malaysian example, where its government received strong resentment even after providing 18 months to firms in the country for a single-mode GST preparedness? Given the complexity of the dual-model suggested for India and the state of technology preparedness prevailing, anything under 2 years appears too hurried.] Three, the big Q – what threshold rate will be acceptable to the Centre and States alike?

[Remember, it’s the GST Council that will take a call on that.]

Given the current air of uncertainties, especially with respect to the final applicable rates – how much of a rate differential will exist between IGST and CGST (or SGST) is a question. It will be easier to determine the impact of GST laws on India’s manufacturers and exporters when the final ‘acceptable’ tax rates are announced.

To understand simply how Indian manufacturers will benefit, here is an illustrative example: Say, the Cost of Production (CoP) of good A for an Indian manufacturer is Rs.10,000 and he sells it at a profit of Rs.4,000 to a wholesaler. Scenario 1: Under the current system of taxation, considering a Central Excise Duty (hereafter referred to as 'Excise') of 12.5% and VAT of 14.5%, the final invoice value for the product would amount to Rs.18,033.75. That essentially means that the final buyer, which in this case is the wholesaler ends up paying Rs.4,033.75 in various central and state taxes. [If we consider the wholesaler to retailer and retailer to consumer chain, the tax base broadens due to the cascading effect, which means that each subsequent buyer gets a bigger share of the tax burden in relative terms.] Scenario 2: Under the new GST system, considering the same CoP and profit for the manufacturer, there is no Excise imposed, therefore, the final tax (or taxes), two in this case – CGST and SGST – are applied on Rs.14,000. Let us for sake of comparison say that the total tax burden of 27% (which in Scenario 1 was Excise+VAT), is equally divided as CGST and SGST, each being 13.5%. The final invoice value for the product would amount to Rs.17,780. Under GST therefore, the final buyer (which is the wholesaler in this case) ends up paying less tax (just Rs.3,780), and therefore a lower price for the same good. What this therefore ensures is that Indian companies can sell the same ‘manufactured’ product to firms that are higher up in the value chain (Indian or subsidiaries of foreign multinationals), and these firms can therefore indulge in more competitive exports as a result of lowered costs, and better cash flow and working capital (due to taxes being paid at the point of supply or sales). It appears as though under GST, India’s exports will become more competitive and Make in India will get a decisive boost. But reality can be somewhat different.

One, at present both VAT and Excise are refundable on exports of goods manufactured in India. [We’re ignoring the delays in refunds.] The cost of goods procured by a merchant exporter (wholesaler) for exports will therefore remain same even under the new system (because GST on exports are still zero-rated). Of course, improvement in logistics leading to delays in transport could be a big plus to exporters.
Two, there is serious doubt about the single tax nature of GST, given the State and the Centre components of GST.

Three, at present, many MSME units are eligible for exemption from Excise (as are SSI units with turnovers of up to Rs.1.5 crore). Also, traders and merchants are not liable to pay excise duty, which is the main indirect tax component of the Central government. Plus, all categories of goods are not covered under Central Excise regime. With GST coming into force, the payment of Excise Duty (that gets included in CGST) is a part of taxes right up to the point of sale or supply.

Four, given that the Centre has now promised to compensate states (especially those that are manufacturing hubs and fear loss of revenues from the new tax-at-point-of-sale regime) for any revenue loss in the first five years of rollout of the proposed indirect tax regime, there is little doubt that the standard GST rate (which will be set as close to the Revenue Neutral Rate as possible) will be higher than what was being imagined originally. A CGST and SGST combine of anything under 18% is out of question. Between 20-25% looks most likely (higher than the global average of 16.4%).

Five, there are currently hubs in the states of Himachal Pradesh and Uttaranchal that enjoy an excise tax holiday on manufactured products. It is unclear whether area based exemptions will continue in the GST regime. Perhaps they will be asked to pay GST on the manufactured goods, and given a tax credit or a refund. More word is required on it.

Six, greater clarity is needed on how taxation on ‘imports for exports’ goods is to be treated. It is understood that BCD will continue to be levied under GST. In fact both CGST and SGST will be imposed on cost of imported goods plus BCD (CIF+BCD). But with CVD (Excise) and ACD (SAD) being absorbed into GST, more information would be needed on what transformation Drawback Rates will undergo. Let’s consider three products that India is importing from two countries for sake of comparison. One, black matpe seeds (urad dal) whose imports (from Myanmar) are subject to BCD, CVD and ACD of 0% each. Two, steel utensils, on which a 10% BCD, 12.5% CVD and 4% ACD are levied (from China). Three, diammonium phosphate (from China), on which 5% BCD, 0% CVD and 1% ACD are imposed. Three very different products that are subject to very unique import duties. Imagine that an Indian importer procures these three products, and after adding minimum value required for the goods to qualify as exports, subsequently exports them from India. Two questions therefore. One, the current Drawback Rates schedule was designed to incorporate ‘total’ duty paid on inputs used in exports (remission up to levels permitted under SION). That includes BCD as well. But since under GST, BCD would be chargeable, an already complicated percentage system of refund will become more complicated. How changes in the AIR of Drawback will reflect the refund limit to the amount of BCD embedded in the export product is yet to be understood by India’s exporters. Hopefully, there will be Science applied to alter the Drawback Rates. Now let’s get this straight with god and pray that with GST, will come more clarity on DBK Rates and that SION will come closer to being a logical standard.

Seven, beyond Drawback, the current customs import tariff is loaded with exemptions that are likely to be reviewed. What could result are changes in many export-linked duty exemption and remission schemes where exemptions will only be allowed from BCD, but not IGST. These changes will for sure lower the appeal of key schemes under FTP like MEIS, SEIS, EPCG, Advance Authorisation, etc.

Eight, the Customs valuation principles that have been adopted for GST purposes is a new phenomenon that Indian companies will have to follow. For instance, valuation through ‘computed value mechanism’ which is prevalent in the Customs valuation norms does not exist in the current form of excise duty or service tax or even VAT laws. Plus, Indian service providers may not be comfortable with valuation of their services by using the ‘computed value mechanism’ as that may reveal their margins on services provided.

In terms of industries, the impact, especially if you look at each of them from a domestic consumption viewpoint will be varied. For some it’s good. For others, the impact will be largely positive. For example, with duties on electronic goods – from mobile phones to laptops – set to rise from the existing level of about 5-16% to in excess of 20%, the cost of electronics will automatically rise. On the other hand, estimates for fall in on-road prices of automobiles range anywhere between 8-18%, depending on the final rate of GST. GST is therefore good news for the auto industry. In one line, it’s largely favourable for Consumer durables, FMCG, Cement and Infrastructure, but not so for Wind energy, (electricity) discoms, pharmaceuticals, etc. For services, there is more bad news than good with telecom companies, insurance, hotels and airlines taking a hit on the increased tax incidences.

Interestingly, in the impact report submitted by the committee led by Chief Economic Advisor Arvind Subramanian in December last year, recommendation for final GST rate was 15-15.5%. It was suggested that lower rates be kept at 12%, with standard rates varying in the 17-18% range. Why such numbers? Allow me to give you an example: In India, hotels and restaurants are subject to service tax, VAT, and luxury tax. Though the impact of GST would depend on the tax previously levied by various states, the CEA-led Committee had concluded that, “If the GST rate gets capped at 18%, the impact is likely to be neutral as presently service tax payable by hotels is around 8.7% and luxury tax at around 8-12% (depending on the state and type of service). Restaurants have to pay service tax at around 5.6% and VAT at around 12%-14.5%.” Obviously, the hotels probably won’t drown under the additional taxes, but over a prolonger period, they’ll definitely feel hurt. And ‘hurt’ businesses weren't what GST was meant to create!

Yes, GST will make logistics smoother, reduce transaction costs and wastages, eradicate the multiple layers of overlapping taxes, bring in uniformity of tax rates across states, and reduce levels of corruption. GST has its goods, but how far it will go in making India a manufacturing and exports hotspot is to be seen when the GST Council uses its pen. Short term inflation spiking is a likely repercussion of GST implementation (as seen in Singapore in 1994).

It is also important to understand if GST really will impact exports. Currently, 160 countries have introduced GST in one or the other form. While most of them have a unified GST system, the most notable example of a dual GST system adopted in a nation similar to India (being amongst the BRICS) is Brazil. It may not be completely appropriate to compare the impact of GST on exports of the two nations because Brazil's portfolio of exports is very different from that of India’s. But let us still take a quick dig at it in a line. Monthly exports from Brazil averaged $4.48 billion in the 63 years leading to July 2016, with the lowest being recorded within a year of GST implementation in Jan 1965 (of $75.06 million only!). What a coincidence! While NCAER has predicted that exports would increase by 3.2-6.3% in the long run, it is known that benefits will only result from an interplay of tax and non-tax factors.

The impact of GST on exports will largely depend on how inflation turns out and how smooth is the implementation process.

In recent weeks some fantastic steps have been witnessed that promise changes for their sectors. For instance, the Special Advance Authorisation Scheme was added as an amendment to India’s FTP on August 11, 2016, to boost exports of articles of Apparel and Clothing Accessories. This was a much needed move, especially given that textile export from India fell in FY2016 and the Trans Pacific Partnership threatens to further shrink India's textile exports over the next few years. Another industry, another bright spot. Food processing. After allowing 100% FDI in food processing sector through automatic route and in retail marketing of food products produced and manufactured in India through approval route, the ministry has now reduced the excise duty on food processing and packaging capital goods from 10% to 6%, and declared a five year-long tax free earning period for newly set-up food processing units and 25% exemption on profits thereafter for another five years. Now that sounds more like the real Make in India move, the real Make for the World move; feels like we’ve got one sector that’s likely to give China a run for its money!

Like I said earlier, there’s always an upside to a downside. During a time when our exports are not living a dream, and manufacturing needs more than just vision and promises, we hope that GST will bring in a downpour of good news and prove Murphy's law wrong. And that our policymakers will take decisions that aid our exim community. No point betting on a pack of face-down cards. GST alone will not have foreign investors flock to India. Parallel strategies need to be implemented to do magic with India’s fortunes in foreign trade. If GST is about a real roadmap, then planned progress has to accompany the reform. The Centre and States should come together to ensure that our exporters don’t just survive on hope. Let the next decade be a decade of perfection and intolerance to average will. Let’s make our 70th Independence Day count!