As GST Council approves the new GST regime, there has been much over-enthusiasm from the business press regarding the same. I believe it’s best to keep our expectations grounded.
For this blog, I am going to assume that the GST cut is permanent, states are not compensated (as it appears to be the case), but the Central Government does not cut spending or raise taxes elsewhere (very generous, I know).”
- GST Cut creates only a one-off increase in the Output Level
It must be remembered that tax cuts are a one-off increase in the purchasing power of the non-Government sector. GST (or any other tax, for that matter) is a continuous flow of financial assets (money) out of the non-Government sector. So, even if output and income are growing, the tax continuously drains demand and results in lower output in each period.
A tax cut, similarly, assuming no austerity on the Government side, results in a larger Government deficit in every consecutive period (not as a percentage of GDP but in nominal terms). GDP remains higher permanently in nominal terms.
BUT: GDP (output growth) is only a one-off, as there are leakages in the spending cycle. For example, savings, workers save more and capitalists hoard more; another is the external deficit, since India runs a current/trade deficit in the external sector; and finally, other taxes remain.1
Each rounding of spending results in leakages and the tax cut fizzles out.
2. Oligopolies and monopolies have pricing power
In India, many sectors like FMCG, Automobiles, Cement, etc. have firms with pricing power. So, when GST is cut, the cut may not fully passthrough to households. Firms could either pocket the GST cuts (a leakage if going into cash hoards) or passthrough only partly, where households only get less of the cut.
If firms seek higher profits, the increase in consumption would be lower since firms have less propensity to consume than households, i.e., they hoard more in the form of ‘savings’. Hence, the demand boost is weaker even if the sectoral balances show higher non-Government wealth.
Anti-profiteering regulators will play a significant role in influencing and punishing firms, getting them to do the right thing and cut prices accordingly.
Conclusion:
I believe the GST cut’s positive effects are exaggerated by the business press. Even in the best-case scenario, it will only have a one-off impact on GDP growth. And given that there are massive private and foreign spending cuts due to the Trump shock, it is unlikely to have any noticeable impact on those income and spending losses. It is, at best, a small cushion against that shock.
That’s all.
- https://en.wikipedia.org/wiki/Complex_multiplier ↩︎