India just took a big step towards transforming into ‘a single common market’

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In a historic move on Wednesday evening, India’s upper house of parliament passed a constitutional amendment that clears a path for the most significant tax reform for India since independence.

That tax reform would be the Goods and Services Tax (GST), which would replace at least 17 state and federal taxes with one unified tax and put India on the path toward being a “single common market.”

The GST has a lot of potential benefits, number one simply being a substantially simplified tax structure. According to a note from Morgan Stanley, India is ranked 157 out of 189 countries by the World Bank for "ease of paying taxes," reflecting how inefficient the current system is.

The unified structure should also integrate state economies more smoothly, allowing goods to move more easily across state borders; and increase tax compliance by making it easier for businesses to follow the tax regime.

And of course, this should all increase tax revenues for the government, assuming the tax isn’t too high.

The upper house’s approval of the bill has been called a "milestone" in Prime Minister Narendra Modi’s reign. Modi is known for his pro-business stance and extensive plans for reforms and progress in India, some of which have been credited for India’s gradual GDP growth over the past few years.  

But he’s also been criticized for not doing enough during his two-year reign. "Elected in 2014 with a promise of bold economic transformation," the New York Times writes, "he had been unable to marshal parliamentary support to pursue several of his central initiatives, such as overhauling land and labor laws."

So the amendment’s approval by the upper house, in which Modi’s party was a minority, is a major success for Modi and his party, and signals faith in the government’s ability to carry out reforms and helps reestablish India’s reform credential.  

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However, it’s still unclear what the effect of the GST will be. Finance Minister Arun Jaitley stated that the tax will boost economic growth by 1 to 2 percentage points, and a new research note from HSBC estimates that it could add 80bps to GDP growth.

But that all depends on what the actual tax rate is going to be. Currently it’s estimated that it will be between 15% and 18%, and won’t apply to alcohol products, petroleum, and electricity.

Moreover, a recent note from Societe Generale says that the generous estimates could be massively over-hyped, and that the claim that it could boost GDP by 1.5 to 2% is “not backed by any meaningful research.”

The note also references a recent paper from Bibek Adhikary, which found that while VAT does have a positive impact on the economies of wealthy countries, it doesn’t seem to have any significant impact on poorer countries. Societe Generale is also skeptical that the GST will increase tax compliance that significantly, especially if the standard GST rate eventually ends up higher than it is now.

However, most experts agree that whatever happens in the long run, the short-term impact is probably going to be messy. HSBC sees adjustment costs for the private sector as well as the central government, and there’s probably going to be a short-term inflation increase.

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