The monumental indirect tax reform, the Goods and Services Tax (GST), has completed five years in existence. Before the implementation, it was said that it would be a boon to the economy in terms of higher revenue buoyancy, lower inflation, higher revenue, higher growth, and so on. On the completion of GST’s five years, it makes sense to ask what happened to inflation.
During the 12 months preceding GST implementation, the Consumer Price Index (CPI) inflation was 3.66%, while it increased to 4.24% post-GST in the next 12 months. However, India is not alone in witnessing higher inflation. A similar pattern was observed in Australia, New Zealand, and Canada. An Australian Competition and Consumer Commission study showed that GST initially increases inflation.
Based on the actual inflation numbers, one can conclude that GST had an inflationary impact on India. But this is not the correct approach to understand whether GST raised inflation in India. Before we systematically examine this issue, let us understand how GST can affect prices.
Understanding the mechanism
In theory, implementing GST should not lead to a change in overall inflation. The revenue-neutral rate (RNR) is calculated so that it would not cause higher inflation. But revenue neutrality does not mean that prices would not go up or down in the economy. This is because the weight of goods in the consumption basket and their contributions to indirect tax collections are not the same. For example, food and drinks (which comprise 46% of the CPI index), rent, and clothing are all significant parts of the CPI basket that are either not taxed or taxed at low rates.
Importantly, the effect of GST on the prices of certain goods and services depends on the structure and design of taxation, such as the level of exemptions, the rate structure of GST, the weight of goods and services in the CPI basket, the tax base, the efficiency of the administrative machinery, and so on.
The RBI, in a 2017 report, showed that about half of the groups of items that GST covers are not in the CPI basket. This study found headline inflation might rise by ten basis points only. So, the effect of GST on prices was expected to be small. Finally, prior to the GST implementation, it was expected that prices would go down because GST harmonises indirect tax rates and eliminates the cascading effect. Thus, whether GST has any effect depends on how different factors affect each other.
So, how can we ascertain whether GST has had an inflationary impact in India? To answer this, we turn to statistical modelling, which will give us a precise and neat estimate of the causal impact of an intervention. In a nutshell, this model uses pre-intervention data (before July 2017) to train the data to estimate the counterfactual estimates of inflation. A counterfactual estimate is nothing but an estimate of inflation if the intervention (in this case, GST) had not occurred. Then the causal estimate would be the difference between the actual and the counterfactual trends. The outcome variable chosen is retail inflation (CPI).
Our statistical results provide us with an interesting picture of the impact of GST on price levels. First, we look into the overall price index (CPI). Here, the actual CPI growth in the study period is 4.61%, whereas the counterfactual estimate of inflation is 3.24%. This implies that without the GST implementation, the CPI inflation would have been 3.24%. This indicates that with the implementation of GST, CPI increased by 1.37 percentage points (pp). Second, we also find that CPI core inflation (which strips off volatile components such as food and fuel from the headline inflation) increased by 1.04pp in the post-GST period (actual inflation was 4.57%, counterfactual inflation was 3.53%).
Third, GST is found to have a significant positive impact on inflation of commodity groups such as paan, tobacco and intoxicants, clothing and footwear, housing, and miscellaneous sectors (mainly consisting of services).
In the case of non-exempted food and beverages, implementation of GST is found to have a negative impact of 4.42% on price levels.
Rise in inflation post GST
The rise in inflation post-GST implementation could be due to the rise in the tax rate of some goods and services, the inclusion of business activities that were not taxed earlier, or the market structure. The average weighted GST rate was designed to be neutral, so it might not have contributed much to the observed higher inflation. Coverage of business activities under GST not taxed earlier would result in higher prices since the firms would pass on the cost to the consumers. Although the informal sector suffered following GST implementation, many firms have jumped to the tax net to take advantage of input tax credit and escape from the punishing reverse charge mechanism.
There is another possibility which would cause higher inflation after the GST implementation. Textbook microeconomics teaches us that market competition leads to lower prices. And when market power increases, prices increase, and profit follows. As Nobel Prize-winning economist Joseph Stiglitz opined, rising market power is bad for the economy as it raises economic inefficiency and lowers the economy’s resiliency. Further, taking advantage of market power, it is possible that most firms would have passed the taxes to end consumers, resulting in a cost-push inflationary impact of the GST.
Our statistical exercises provide conclusive proof that GST implementation has had an inflationary impact on the Indian economy. Let us recall that prices of petroleum products increased significantly, which might have contributed to the rise in CPI after the GST implementation.
To summarise, our statistical results suggest that GST implementation has resulted in a decrease in inflation of food items and raised inflation of non-food items such as CPI, paan, tobacco and intoxicants, clothing and footwear, housing, miscellaneous, and non-exempted food and beverages.
Our analysis suggests that prior to GST implementation, market concentration measured by various indicators was rising, suggesting an oligopolistic market structure. This determines whether the benefits of GST are passed down to the consumers or not. However, withpa the existence of market power, firms’ price includes a significant mark-up over marginal costs. Our results point out the possibility of profiteering in select segments after GST. To pre-empt this possibility, the government set up National Anti-profiteering Authority (NAA) to ensure companies did not use GST as an excuse to raise prices.
Our findings suggest that NAA should monitor the prices of critical or essential goods and services to see the price impact of GST. Similarly, the Competition Commission of India should observe anti-competitive producer behaviour that hurts consumers via excessive price increases. These measures may ensure that producers do not take advantage of the GST.
Santosh Kumar Dash and Anoop S. Kumar are Assistant Professors of Economics at Gulati Institute of Finance and Taxation, Thiruvananthapuram. Views are personal