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GST – Impact on Small Industry and the Informal Sector

The Goods and Services Tax (GST), that came into effect on 1st July, 2017, has been lauded as the most comprehensive contemporary reform of Indian indirect taxation. Aimed at creating a common, unified and integrated domestic market, allowing the free flow of goods and services across state lines, GST is supposed to deliver Indian industry and thereby the economy the competitive edge apparently lacking till now.

Reality is however a far cry from the picture painted by government. GST by creating platform a conducive to economies of scale and nullifying regional tariffs, is both conceptually and practically advantageous to big business and detrimental to the informal sector and small businesses.

These groupings, informal and small, though quite different have some degree of overlap. Informal business is overwhelmingly small but not all small businesses are informal. GST’s impact on these groups is quite different both with regard to extent of impact or in terms of results sought.

Small Business under GST

Small business in India is defined, on the basis of investment in plant and machinery, as either micro, small or medium enterprises. These, collectively called the MSME sector, form the backbone of the Indian economy. 

Enterprise
Investment in Plant and Machinery
Manufacturers
Service Providers
Micro
> 25 lakh
> 10 lakh
Small
> 5 crore
> 1 crore
Medium
> 10 crore
> 2 crore


The Government of India MSME Annual Report (2015-16) states that MSMEs employ an estimated 1,171.32 lakh persons and contribute around 37% of GDP. As developing countries are characterized by capital scarcity and labor abundance, MSMEs with lower capital-output and capital-labour ratios than large-scale industries, better serve growth and employment objectives. Not only do MSMEs generate the highest employment per capita, they also check urban migration to a great degree by providing people living in rural areas with a sustainable source of employment. MSMEs are instruments of inclusive growth, catering to the needs of the local economy, touching upon the lives of the most vulnerable and marginalized while providing for many families, their only source of livelihood. 

GST’s impact on the MSME sector is tri-pronged. The first involves a substantial reduction in the turnover based exemption threshold. Turnover exemption under Indian indirect taxation, be it excise, service tax or VAT, even GST, is generally two tiered. The bottom tier are those enterprises completely exempted from taxation and compliance while the upper is partially exempted by a reduction in the rate of taxation and level of compliance. This partial exemption could be generally applied to all eligible assessees or only to particular categories of assessees.

Tax
Complete Exemption
Partial Exemption
Excise
(Manufacturers)
Up to 1.5 crore
Exemptions on a variety of factors including goods manufactured, location, etc.
State VAT
(Traders)
Upto 5 lakh
Upto 40 lakh *
Service Tax
(Service Providers)
Up to 10 lakh
Service centric exemptions
GST
(All Firms)
Up to 20 lakh (10 lakh in NE)
Upto 75 lakh

*Only for local traders who trade within statelines

It is evident from the table that GST severely reduces the exemption to manufacturing in the MSME sector. 75 lakh (including the partial exemption) may cover micro enterprises and the bottom part of small, but medium and the upper section of small manufacturing has had its exemption stripped away and is being treated on par with big business. Even manufacturing units with turnover between 20 lakh and 75 lakh in spite of retaining a partial exemption, are burdened with a non-transferable tax rate of 1%. As all indirect taxes are ideally transferable to customers via a hiked price and not actually borne by the enterprise, this 1% directly touches the profitability of micro and small enterprises to which it applies. Also, those under a composition scheme (partial exemption under GST) are additionally burdened by being denied the benefits of input tax credit and hence cannot set off taxes paid on inputs (passed on by the supplier by a hiked price) from those payable on outputs, paying only the difference.

Even benefits from an increased GST exemption for traders when compared to the limits prescribed under the State VATs must be factor in the loss of exclusivity to local traders. VAT’s composition scheme (partial exemption) was applicable to a firm only on satisfaction of certain conditions one of which was that all purchases and sales made by the firm were local, within the state. By negating the locational clause, small local traders and the employment they generate are left open to competition from outside the state. Admittedly, service providers have substantially befitted but service provision especially when job work (exempted separately as under the previous regime) is excluded pales in comparison to manufacturing and trade, from an employment perspective.

GST’s second blow to MSMEs comes from the abolition of regional tariffs. The absence of entry taxes, interstate levies, octroi, etc. has stripped small industry of its state sponsored protections leaving them open to being undercut out of markets by bigger firms operating at far greater economies of scale. Also, for these bigger firms, GST has had a tremendous impact on logistics cost with nearly a 30% reduction being witnessed. Abolition of state levies dispels the need to maintain state-wise depots to facilitate un-taxed stock transfers. For example, previously if one were to sell goods, manufactured in Maharashtra, to customers in MP, it was cost effective to incur capital costs needed to create depots in MP, to avoid interstate levies. These costs not only created a competitive edge for localized industry but also created employment and investment in the poorly industrialized states. Under GST, goods manufactured Maharashtra will be treated on par with those made in MP, nor will Maharastian businesses be incentivized make investments in MP. Instead, it may be more cost effective to deliver straight to MP based customers sans a depot and resulting in a shrinking of MP’s job market, investments and industrial base.

Third in GST’s major impacts on MSMEs is the compliance cost. For a business in an ideal situation the following returns apply. 

Return
Due Date
Description
GSTR 1
10th of the following month
Details of outward supplies (sales)
GSTR 2
15th of the following month
Details of inward supplies (purchases)
GSTR 3
20th of the following month
GST Monthly Return
GSTR 9
31st December of the following year
GST Annual Return
GSTR 4
18th of the month following the quarter
GST Quarterly Return for Composition Scheme Assesses
GST 9A
31st December of the following year
GST Annual Return for Composition Scheme Assesses

Thus for any firm with turnover in excess of 75 lakh, there are 3 monthly returns and one annual, totaling to 37 returns per year. While those with turnovers between 20 lakh and 75 lakh, there are 5 returns (4 quarterly and one annual). This however, as mentioned before, represents an ideal situation.

GST compliance runs on the Goods and Services Tax Network. GSTN in order to improve compliance and facilitate easy transfer of input tax credit, attempts to link sales made by a particular firm to purchases made by another by matching invoices on a one to one basis. The real time accounting of invoices, inward and outward, that GSTN envisages is beyond the reach of most MSMEs in terms of human resources, hardware and software costs. What does happen in most of small industry is that records are maintained manually with periodic digitization of the information collected in order to appease tax authorities under government diktats to promote e-filings. The number of e-returns filed cannot be directly converted to quantify the extent of digitization in book-keeping. Periodic digitization of manual data, mostly likely done in one go as the due date approaches, is bound to cause errors, especially when GST compliant invoices contain 11 significant fields of data. When an invoice is incorrectly reported, it not only inconveniences the assessee but also other person in the supply chain. If for example, if one firm were to make a mistake with regard to an outward invoice, GSTN’s one to one matching of purchases and sales, will throw up an error to a customer of the firm who would have declared that particular invoice as purchase to obtain input tax credit. This would necessitate filing additional returns; GSTR 1A - details of outward supplies corrected or deleted by the recipient and GSTR 2A - reconciliation of inward supplies received by business based on GSTR-1 furnished by the supplier (GSTR 4A replaces 2A for assessees under the composition scheme). Any collection of tax deducted at source , mandated for a variety of payments, would add two more monthly returns (GSTR 7 and GSTR 7A). Hence, for a minor error which may not even be committed by the assessee, the number of annual returns shoots up to 73. And all this is per state. If a firm were to operate in more than one state, an entirely new set of returns needs to be filed. The compliance burden is certainly far greater that existing under the previous regime where a monthly return and an annual one were the norm. Also, as if to rub salt in the wound, errors requiring the filing GSTR 1A, 2A or 4A, will delay the availability of input tax credit to the assessee. This would increase the working capital requirements of compliance burdened small firms already operating at barest of margins in a market with increased competition.

Recurrent return filing is surely tedious if not complex and for many MSMEs migration to a computerized system suited to GSTN poses a challenge. This will necessarily involve substantial investment into domains of accounting, booking keeping and compliance not to mention installation of digital connectivity. Funds to facilitate such investment may not be easily available to MSMEs. To recoup or even generate funds for GST compliance, firms will either have to cut other costs or increase revenues.

Attempts to reduce variable costs to offset compliance expenditures or face increased formalized competition would, in the MSME sector, be centred on wages paid to a predominantly informal and unorganized labour which would have significant repercussions on economically backward sections of society. Any increase in revenue via a price rise will adversely affect MSME market share and profitability especially in areas of competition with formalized corporatized industry, for which GST compliance, due to reduction of applicable laws, will most likely result in compliance cost decrease. Big business, due to the convoluted nature of the pre-GST Indian tax structure, is already in possession of highly complex accounting and compliance platforms. For these big firms, GST implementation would actually result in cost savings under the accounting and compliance head as their systems could now be streamlined to deal with fewer applicable taxes. Hence an increase in sale price by smaller firms due to increased compliance costs would not be replicated by bigger firms which would eventually lead to a shift of market towards big business.

This eventual trend is reinforced by the presence of an anti profiteering clause (Clause 171) whereby the savings accrued to an enterprise from a reduced rate of tax have to be passed on to the consumer. The ironic aspect is that in spite of its populist undertones, the anti profiteering clause is unashamedly pro big business. Leaving aside the accounting and compliance cost of proving that one isn’t profiteering from a reduced tax rate which will further burden MSMEs, the 2 year moratorium on the usage of such tax savings to meet compliance costs will add to the economic costs borne by MSMEs from GST implementation. GST, though hopefully not designed to be anti-MSME, may turn out to give big business a boost in encroaching into MSME market share due to high compliance costs, simplification of taxation and unification of the market.

GST and the Informal Sector

Economies of developing countries are generally split between a formalized portion and that which operates outside such. The latter is called informal, extra-legal, unorganized, shadow, etc. and is sometimes even vilified as the black economy. The informal economy is predominantly un-regulated, un-taxed and un-banked, using hard currency as the main medium of exchange. These units typically operate at a low level of organization, with little or no division between labour and capital as factors of production and on a small scale. Labour relations where they exist are based mostly on casual employment, kinship or personal and social relations rather than contractual arrangements with formal guarantees. Rather than forming a parallel to the formal economy, there exists a great deal of interaction between the two. Formal industries constantly tap into the informal sector as a source of cheap goods, services, labour and distribution networks. This interaction occurs at various stages of the commodity life cycle, from small unregistered factories manufacturing parts of a commodity to street vendors being the final stage of distribution.

The GSTN’s invoice matching methodology poses a severe constraint to the interaction. As informal sector units will be unregistered, their inability to raise a GST compliant invoice will hamper the input tax credit transfer to formal units lower down in the supply chain. This will force to formal players to either shift to other formal sources leading to a marginalization of informal services and manufactures. To avoid losing market shares, informal businesses will have to formalize. Also, GSTN by creating a central database containing all transaction data can greatly aid tax officials locate informalities in commodity supply chains so as to forcibly formalize. This is evidenced by the supposed 30% in the tax base in the post GST period.

Admittedly, formalization is not necessarily something to forebode. The informal sector by operating outside the ambit of legislation is the breeding ground for a host of labour violations. Standards and rules regarding minimum wages, discrimination, work environment, statutory dues, exploitative practices etc. are constantly ignored with officials and inspectors either unaware or bought-off. This results in substantial exploitation of labour in the informal sector, both in terms of precariousness of employment and paucity of wages. As most of the informal sector’s labour is recruited from sections of society that are marginalized in socio-economic terms, it only compounds the extent of exploitation. With formalization of these units, their labour too will obtain access to legal rights and redressal mechanisms and possibly better wages and working and employment conditions.

Formalization will also ideally allow informal units to access credit from financial institutions. This not only helps avoid usurious informal lenders but also provides provides a platform for capitalization of assets in order to mobilize resources. Hence it is logical to bring informal units within regulatory framework. In the micro sense, to both impart legality to enterprises suffering at the hands of corrupt officialdom and to enforce fair wages, decent working conditions and labour dignity. And in the macro sense, to include formerly informal sector data in the quantification of macro economic stats like GDP, industrial growth, employment figures, etc. so as to tailor governmental policies and initiatives to ground realities while creating a base for expanding the tax net if need be.

The problem then doesn’t revolve around whether to formalize but in its manner. The government is apparently under the belief that aggressive confrontational measures are the need of the hour. Demonetization combined with Jan Dhan accounts and other financial inclusion measures sought to neutralize the informal sector’s medium of exchange while GST imposes massive regulatory and compliance framework in an attempt to bring the sector within the tax net and thereby decrease profits. Being subject to such measures, without the adequate infrastructural and financial support which should ideally be provided by the state, may kill informal industries which already operate on slim margins.

The fall-out of this will be catastrophic. 90% of India’s over 47 crore strong workforce is in the informal sector. Of the 64 lakh new employment opportunities recorded during 2000 - 2010, about 76 percent were in the informal sector. Of the 24 percent newly employed in the formal sector, 81 percent were informally employed, but that is another issue altogether. The labour employed by the informal sector is predominantly unskilled and uneducated. These workers do not have the privileges—like social security and workplace benefits—enjoyed by their counterparts who are formally employed. In spite of a greater degree of worker exploitation, the informal sector’s labour absorption capabilities make it the dominant force in the Indian economy. It is then crucial that this sector receive the requisite structural, legislative and most essentially financial support to improve productivity and wages as its formal counterpart has displayed a historical incapacity to employ the existing and potential labour force, bolstered by an ever increasing shift from agrarian employment. As ILO and NSSO data point out – out of total net addition to jobs in the economy, the bulk is in the informal sector.

Beyond being merely a depot to park excess labour awaiting formalization, the informal sector’s contribution to the Indian economy is quite substantial, whether captured in statistics or not. A Report of the Committee on Unorganized Sector Statistics states that as of 2005, the informal sector’s contribution to Gross Value Added (GVA), which is GDP sans taxes and subsidies as neither apply to informal units, stood at around 50%. Its contribution to GDP too stood at around 50% as per the NCEUS Task Force Sub Committee's Report on Contribution of the Unorganized to GDP. While the organized sector has lagged in recent times, in terms of growth, the informal sector has shown improvement in productivity, real wages, employment and capital accumulation. It is wrong to look down upon the informal sector as stagnant and under-performing, having done better than its formal counterparts on economic parameters such as investment, job creation and accumulation of fixed assets.

With such an integral role to play in the Indian economy and employment not to mention being crucial to meeting the government’s commitment of creating 2 crore jobs annually, the government’s step-motherly treatment of the informal sector is quite hard to comprehend. Popular perception sees it as a unregulated parasitic with no contribution to tax income of the government. This perception has led to the informal sector being demonized as a den of illegality, black money, etc. as evident from many statements made during the demonetization months and hence justified as a target for variety of initiatives aimed at its extinction. Such attitudes indicate a misunderstanding of how the informal sector came to exist and why it perseveres in spite of various measures.

Informal economies do not develop as part of some machiavellian plot to avoid taxes . On the contrary they are developments arising out of people’s struggles to create economic activity in spite of a legislative and regulatory environment whose formulation and implementation is divorced from ground realities. In many developing countries, as in the case of India, the legislative and regulatory framework used to monitor economic activity was derived from western models. These, when gradually developed in their host countries, incorporated a whole slew of informal arrangements into formal structures and thereby created an easy migration for those sectors sought to be integrated. A good example would the formalization of property laws of the American west. As most developing countries to promote post colonial industrialization, relied mainly on public sector and large private capital, the regulatory framework created was tailored for economies of scale. As these industries proved incapable of meeting the economic and employment demands of an increasing workforce either due lack of growth or capital intensification, the informal sector grew to meet both needs. Unable to bear regulatory costs and maintain profitability, informal units operated outside the formal industrial framework, creating a shadow economy. The limited profitability of informal industry is due its consumer base belonging to the lower economic strata and due to a lack of resources to reduce costs by economies of scale.

Informal economic development is primarily a fault of poor governmental planning or private sector prioritizing profits over larger economic interests. As this sector employs an overwhelmingly majority of the workforce, reforms aimed at formalizing must be extremely sensitive towards imposing additional cost as firms going under may result in mass unemployment. The libertarian economist, Hernando De Soto in fact stresses repeatedly on reducing the cost of legality (both migratory and recurrent costs) as central to any attempt to successfully formalize without damaging the informal economy. These costs constitute any and every expenditure or loss of revenue and profits that need to be borne to enter and remain within the formal sector. Though proposed in relation to property rights, parallels can be easily drawn for formalization of industry.

The Indian government, hell bent on blazing its own path, ignoring advice from either end of the political spectrum, seems to be under the impression that bludgeoning the informal sector into submission is the best way forward. This strategy, manifesting as either GST, demonetization, digitization, etc., refuses to recognize the risk it places on the informal sector and all its dependents. Any shrinking of the informal sector, not compensated adequately by expansion of the formal both in terms of employment and economic output, will not only hamper economic growth but threatens to convert the much touted Indian demographic dividend into a Malthusian tragedy.

To summarize, GST’s impact on the informal sector may not be direct as in the case of MSMEs. But if viewed in light of an overarching drive to formalize, materializing as a variety of strategies, its impact could be even more dangerous to the economic health of the country.

Conclusion

The Goods and Services Tax reform, though laudable in its ideals, to create an easy unified platform to facilitate business, practically manifests as a severe disadvantage to small and informal firms. The migratory process itself, if to be performed in a manner that won’t hamper industrial performance, requires access to substantial resources. During a round table discussion conducted by the Business Standard on exploring GST in the post euphoria period, the CFO of PepsiCo defined the company’s transition as a smooth experience. He went on to describe PespicCo’s investments in conducting internal training programmes, consulting experts and interacting with it’s supply chain members as crucial to this process. When questioned as to whether such measures could be adopted by smaller firms, he remarked that size was irrelevant. All of what was highlighted by PepsiCo’s CFO were measures necessitating either access to sizable finances or dominance in the supply chain. Nothing really within the grasp of small industries or informal units. What was not touched upon was that for firms of the scale of PepsiCo, already running on advanced Enterprise Resource Planning softwares (ERPs), the additional compliance burden caused by GST is immaterial. The PepsiCo. CFO also mentioned that numerous firms did not prepare for GST as they doubted its implementation, in contrast to PepsiCo which displayed a firm faith in the government’s resolve. Sidestepping the corporate-state nexus being alluded to, GST took a good 17 years to develop from Vajpayee’s appointment of Asim Dasgupta to lead a GST committee in 2000 to July of 2017. To expect small and informal businesses to plan strategically for decade spanning fiscal developments, exhibits either sheer ignorance or a shocking lack of concern. At the same event, the Secretary to the Department of Revenue brushing aside numerous complaints regarding compliance warned industry to buckle down and face facts. He then claimed that all achievements come at a cost, not specifying who would bear the brunt.

That a good number of small and informal businesses will survive GST is quite possible as the sectors have historically displayed a strong degree of robustness and flexibility. However, quantifying the impact on employment and economic potential is hard to determine to due to extreme heterogeneity of the sectors and lack of data. Two thing though are certain, as evident from the statements of aforementioned representatives of big business and state; GST is highly advantageous to big and the state is unconcerned.

The impact of this on the end consumer is two fold. Consumption in India, with its extreme economic disparity, is determined by the purchasing power in hands of the poor, simply because of their vast demographic majority. GST’s impact on the costs and market share of small and informal units will indirectly affect the wages of those employed by such. Reductions in the average wages or worker strength in the MSME or informal sector will affect the purchasing power of a vast majority of the population causing a crisis of demand. As this happens, big formal businesses, under far less competition than prior to GST, will necessarily capitalize on the situation to drive up profits and eventually prices. The end-consumers of the country, the bulk of the population, will at an average, most likely be left with a lesser income and possibly higher prices. 

Anirudh Rajan, 
Researcher, 
Public Finance Public Accountability Collective (PFPAC) 

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