India’s Reincarnation as a Unified Marketplace of 1.2 Billion Participants

Earlier in August, as U.S. investors were preoccupied with domestic news on the elections and markets, an interesting development happened halfway around the globe. India’s legislature, after a notoriously long process, approved one of most ambitious tax reforms in history—the Goods and Services Tax (GST) bill. Overall, GST is India’s attempt to create the largest marketplace with standardized tax rates ever. It is also a reminder of the Modi government’s serious push for reforms to make it easier to do business in India. Most of India’s macro factors have improved recently, earnings of corporate India are steadily improving, and the central government is gradually pushing positive policy changes. So, let’s take a look at what GST is and how it affects various sectors of the Indian economy.   What Is GST? Broadly speaking, governments collect revenues/taxes in two categories: • Direct taxes or taxes paid by individuals (e.g., income tax, wealth tax, capital gains tax, etc.) or corporations (e.g., corporate tax) • Indirect taxes or taxes collected by intermediaries (e.g., retail stores) in lieu of goods or services purchased or sold, like a sales tax or value-added tax (VAT) Typically, in developing countries, indirect taxes make up a greater portion of total taxes. In the U.S., taxes on goods and services are 5%¹ of total tax collection, while in India they account for over 30%.² India’s GST is a bold attempt to streamline these indirect taxes and increase tax compliance. Taxes in India are split into an array of federal and state taxes. Not only does every state have its own rate, but each could also levy extra taxes depending on the category of sale (e.g., luxury taxes on high-end hotels, entertainment taxes on movies). GST aims to subsume these taxes under two distinct categories of central and state tax, as shown in the chart below.   Taxes Subsumed by GST State and Central Taxes   What Does GST Aim to Do? • Create uniform taxes across states: This allows firms to base logistics decisions purely on a business basis and not on tax arbitrage, thus improving business efficiency.   • Eliminate the cascading impact of taxes: Currently, businesses need to pay taxes separately to several tax collecting authorities (especially if operating across states), and claiming tax credits is very difficult. This results in manufacturers baking these costs into the price of the product. It is expected expect prices of manufactured items to decrease under GST.   • Create less red tape and paperwork, with enhanced governance: GST will eliminate taxation layers as goods and services move across borders, with the intention of reducing red tape and increasing tax compliance. It will also incentivize dealers to request documentation to claim tax credits from the dealer behind them in the value-added tax chain.   • Level the playing field for organized shops: India’s huge consumer market is highly fragmented: 66% of the $185 billion³ consumer goods market is compiled of un-established brands. As overall taxes come down, organized firms will become more competitive compared to unorganized firms, which tend to keep costs lower by evading taxes. Simultaneously, centralized tax collection will put more pressure on unorganized firms to pay taxes. With GST, India stands to have a seamless movement of services and merchandise throughout the country.   What Is GST’s Impact on Economic Sectors? The key principle of GST is to unify taxation of value-added activities. Currently, manufacturing firms pay excise tax of 14% collected by the central government, a VAT of 12.5% (both without exemptions)⁴ collected by states, and an entry tax collected by municipal corporations. As taxes are streamlined, the overall rate (still being debated) is likely going to be 18% (9% for central GST and 9% for state GST).⁵ Total indirect taxes will come down to 18% from the current three components of 14% + 12.5% + entry taxes. The price of goods should naturally come down. Below are a few sectors affected by GST:   • Sectors Affected Positively: Consumer Durables, Industrials and Manufacturing & Materials   • Sectors Largely Unaffected: Information Technology, Health Care & Pharmaceuticals and Telecom   • Sectors Affected Negatively: Financial Services and Energy   We believe India may have the most long-term potential among emerging markets. Investors willing to take the risk stand to benefit from the long-term upside that India offers, in our view.         ¹Source: World Bank, as of 08/19/2016. ²Source: World Bank, as of 08/19/2016. ³Source: Bank of America Merrill Lynch. ⁴Source: Bank of America Merrill Lynch. ⁵Source: Economic Times, India. ⁶Source: Economic Times, India. ⁷Source: Economic Times, India.