The Other Side of GST

There is a difference between making things simple and making them simplistic. In the zeal to make things simple a significant chunk of media’s coverage on the recently introduced Goods and Services Tax (GST) has turned out to be simplistic. Here’s how.

There are two basic concepts at the heart of the GST. It has a self-policing feature built into it and it allows for an input tax credit. And both are linked.

Let’s start with the second feature first. What is input tax credit? Let’s say you are a manufacturer. The product you make needs different kinds of raw material. You buy this raw material from other suppliers. When you buy this raw material from other suppliers, they have already paid some indirect taxes on it and these indirect taxes are built into the price that you pay.

In the pre-GST era, you could not deduct for the taxes already paid down the value chain, while you paid your share of indirect taxes. In this way, you ended up paying a tax on tax and hence there was a cascading effect on the final price of the product.

GST subsumes many indirect taxes both at the level of the state governments as well as the central government. And that is a good thing because it actually reduces the number of taxes.
With the introduction of the GST, you can deduct the GST already paid as a part of your value chain, while paying your share of the GST. This is referred to as input tax credit.

And how do you get this input tax credit? As Section 16(2a) of the Central Goods and Services Tax Act, 2017, points out: “Notwithstanding anything contained in this section, no registered person shall be entitled to the credit of any input tax in respect of any supply of goods or services or both to him unless,–– (a) he is in possession of a tax invoice or debit note issued by a supplier registered under this Act, or such other tax paying documents as may be prescribed.”

What does this mean in simple English? It basically means that anyone claiming an input tax credit for the GST already paid down his value chain, needs to ensure that his suppliers have registered under this Act (i.e. they have a Goods and Services Tax Identification Number (GSTIN)). The individual also needs to ensure that he is in possession of an invoice from his suppliers.

This is the self-policing feature built into the GST. Anyone claiming an input tax credit needs to ensure that all his suppliers are a part of the GST as well. This basically ensures that if any supplier was operating in the informal economy, he now has to become a part of the formal economy by getting a GSTIN. Wherever this chain breaks, the government knows that somebody is not paying his fair share of taxes. So far so good.

Norman Loayza, an economist with the Development Research Group of the World Bank, defines informality as “a term used to describe the collection of firms, workers, and activities that operate outside the legal and regulatory frameworks or outside the modern economy.” And given this, governments are not able to collect tax from firms operating in the informal economy. The GST is a way of ensuring that these firms become a part of the formal economy and they pay taxes.

Much of the writing in the media has focused on this and passed it as a good effect of the GST, which it is. But saying that it only has a good effect and does not have any negative sides to it, is making things simplistic instead of simple.
Let me explain.

Loayza estimates that in a typical developing country the informal economy employs 70 per cent of the labour force and produces around 35 per cent of the GDP. India has multiple estimates of the size of the informal economy. Take a look at Figure 1.

Source: Boosting Growth and Employment in the BRICS’ Prepared by ILO and VV Giri National Labour Institute, INDIA. September 15, 2016. 

As per Figure 1, nearly 67 per cent of India’s labour force works in the informal economy. This touches nearly 85 per cent, if we take the informal workers in the formal economy into account as well. Many formal firms under-declare the total number of people they employ.
The India Employment and Labour Report of 2014 states: “An overwhelmingly large percentage of workers (about 92 per cent) are engaged in informal employment and a large majority of them have low earnings with limited or no social protection.”

There are other estimates as well. Nevertheless, most of these estimates put the size of the labour force working in the informal economy at around 75 per cent or more of the total labour force. Also, depending on which estimate you believe, the informal economy contributes 35 to 45 per cent of the GDP, which is huge.

The question is why are the firms operating in the informal economy, and not formal? The simplistic answer is that they want to avoid paying tax. And GST will make them compliant on that front.

Many Indian firms operating in the informal economy do so because going formal means following a whole host of rules and regulations, which they simply do not have the wherewithal to follow. The National Manufacturing Policy of 2011 estimates that, on an average, a manufacturing unit needs to comply with nearly 70 laws and regulations. At the same time, these units sometimes need to file as many as 100 returns a year. Furthermore, India has 150 state-level labour laws and 44 central-level labour laws.

GST will force informal firms to go formal, the question is, will they? It really depends on whether it will be viable for them to do so. Instead of going formal, they may simply decide to shut down. This is also a possibility, which the media seems to have taken great care not to talk about. How this will play out, no one really knows and only time will tell. If GST has to be a real success then the ease of doing business in India needs to start improving as well. Nothing much has happened on that front.

If the informal firms shut down, how is the situation likely to play out? Many people will end up losing jobs and this will have an impact on consumption and economic growth.
Will the smaller formal firms cash in on the situation by expanding their production and recruiting more people? Again, it’s not so easy. The average Indian manufacturing firm is very small. In many cases, it employs even less than 10 people.

Many formal firms continue to want to stay small so that they don’t come under the ambit of labour laws. As Jagdish Bhagwati and Arvind Panagariya write in India’s Tryst with Destiny: “The costs due to labour legislations rise progressively in discrete steps at seven, ten, twenty, fifty and 100 workers. As the firm size rises from six regular workers towards 100, at no point between the two thresholds is the saving in manufacturing costs sufficiently large to pay for the extra costs of satisfying these laws.” Panagariya is currently the Vice Chairman of the NITI Aayog.

The situation will end up benefitting the larger firms who will end up capturing a larger portion of the market. And this will give them pricing power as well. Of course, it will mean more taxes for the government, which can then continue with its many boondoggles or create newer ones.
Also, it is worth mentioning here that while the owners of firms working in the informal economy don’t pay taxes, those working in these firms do pay their share. Most of these workers earn lesser than Rs 2.5 lakh. Hence, they don’t come under the ambit of income tax. When they spend the money that they earn, they pay indirect taxes. Also, the money they spend is income for firms operating in the formal economy, which then pay their share of income tax.
Given this, simply arguing that all informal economy is bad, is basically a very simplistic way of looking at things. Ultimately, it provides jobs to three-fourths of the labour force and that can’t be ignored. Hence, it is important that the media, economists and analysts, try to explore this other side of the GST as well. can be reached at

The author can be reached at vivek.kaul@gmail.com.

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