India's inflationary twist

Nadya Mihaylova - 12 July 2017

After 17 years, the Indian government has finally introduced the Goods and Services Tax (GST) which will subsume multiple indirect state and central taxes into one tax structure with four different rates: 5%, 12%, 18%, and 28%. The new reform has been largely welcomed by most companies and consumers across the country, with many hoping that it will bring greater transparency and higher economic growth. Although the headline inflation rate in India has been on a downward trend since last year, dropping from 6.1% in July 2016 to 2.2% in May 2017, the new tax reform could usher in an inflationary surprise.

Whereas some essential consumer items will either be completely exempt or see a drop in the tax rate, the arrival of the GST is expected to increase the costs of most other consumer goods and services in India, including ATM withdrawals, kitchen appliances, and business travel. The new reform is initially expected to have some inflationary impact as the tax burden is passed on to the consumer faster than the tax cuts. This has been observed in other countries, like Australia, when a similar GST tax reform was introduced. has made an early attempt to gauge the impact of India’s biggest tax reform, gathering the prices of 47 essential items, which are taxed under GST and are part of a typical grocery shopping basket, before and after GST was applied (figure 1). According to this analysis, four out of the five cities monitored in the study recorded higher prices. Despite the high level of uncertainty, on balance, the short-term impact of GST is broadly expected to be inflationary: consumer prices are typically more flexible upwards than downwards.

While the GST Bill includes a plan to set up an anti-profiteering body if companies fail to pass on the tax cuts to consumers, this will be very difficult to enforce in practice. Many remain sceptical that prices will fully reflect the reduction in taxes, and predict that businesses will take the opportunity to widen their profit margins.

While core inflation has marginally exceeded the official 4% target, food inflation has been a benign influence on the Indian CPI, aided again by favourable monsoon rainfall. Superficially, low food inflation could open the door for an interest rate cut later this summer, but the central bank is likely to wait and see if the trend will start reversing soon. Higher rural wages and dissipating base effects suggest that inflation will be heading higher towards the end of this year. An increase in July inflation could scupper the hoped-for 25 basis-point interest rate cut.

In the longer-run, however, GST could have a disinflationary impact as the duplication of taxes comes to an end and inter-state competition between producers is strengthened. The main advantage of the reform is the removal of the compounding effect of multiple different taxes at every stage of the supply chain. A recent study by the US Federal Reserve has attempted to quantify the tax saving of manufactured goods under the new system. Column (1) shows that the final tax rates for manufactured goods produced in the state of Andhra Pradesh and sold in the state of Maharashtra is 48% under the old tax system and only 16% under the new GST (figure 2).

Figure 1


Figure 2

Source: US Federal Reserve

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