Cost of Modi Tax Win Yet to Be Paid as Inflation Risk Looms

  • Analysts predict rising inflation, near-term drag on growth
  • New tax could cause pain ahead of crucial state elections

Indian Prime Minister Narendra Modi.

Photographer: Mark Nolan/Getty Images

Prime Minister Narendra Modi this week won India’s biggest economic reform in decades. Now economists are trying to calculate the cost.

After the landmark national sales tax is written into the constitution, the government and lawmakers will need to set the levy that will sweep away state-by-state taxes on $2 trillion of goods and services. The higher it’s fixed, the more it risks stoking one of Asia’s fastest inflation rates, damping consumption and hurting company profits.

And there could be a political cost, too. Modi’s ruling party faces as many as seven state polls next year, when the general sales tax is projected to be introduced. The ballots include the most populous state, Uttar Pradesh, before general elections in 2019. While India boasts the fastest-growing major economy, faster price rises would hurt most the purchasing power of the country’s hundreds of millions of rural poor.

"Inflation is the most consistent electoral issue for the last 50 years," said Nilanjan Mukhopadhyay, who has written a biography of Modi. While GST "will bolster Modi’s image in the global financial markets, it has to be seen if this will have a salutary effect on his domestic image."

Unlike many economies round the world, India’s challenge isn’t battling too-low inflation. Consumer prices rose 5.77 percent in June, the fastest pace in 22 months and higher than the central bank’s target of 5 percent by March 2017. 

The new tax would hit months after inflation hawk Raghuram Rajan’s departure as Reserve Bank of India governor. Rajan is seen holding the benchmark rate at his last meeting on Tuesday, and investors will be watching for guidance on the impact of the GST, along with a pay increase for government employees.

For a survey of economists on the outlook for the central bank, click here

Private economists have already started to estimate the GST impact. Nomura Holdings Inc. and Kotak Mahindra Bank Ltd. say it could add 0.2 to 0.7 percentage point in the first year. Studying the experience of five countries -- Singapore, Australia, Canada, Japan and Malaysia -- Nomura’s Sonal Varma also found that economic growth initially slowed, a view shared by Morgan Stanley.

Modi’s economic advisers said that the impact on inflation will be negligible if the GST rate is capped at 18 percent. If the rate is around 22 percent, then they project inflation to accelerate by 0.3 percent to 0.7 percentage point, mostly due to potential price hikes in education and health services.

Second Term

One way Modi might dodge electoral damage is if holdups delay implementation of the GST, so that there’s no fallout on the state elections, according to Manoj Joshi, a distinguished fellow at the Observer Research Foundation in New Delhi. Following the passage of the constitutional amendment bill, Modi will focus on the 2019 national vote rather than painful reform, he added.

"I think that the GST rollout will be a somewhat extended and slow affair and may not have that effect in the short term," said Joshi. "Modi’s main goal is to get that second term and everything will be subordinated to it."

Lawmakers and the administration are likely to start hashing out details on the law toward the end of 2016, with implementation targeted in the fiscal year starting April 1, 2017.

Both inside and outside government, most agree that as time goes on, the new tax will prove a boon to India’s economy by creating a single market out of the country’s many states. Finance Minister Arun Jaitley predicts it will boost growth by as much as 2 percentage points, and increase government revenue. 

Investors like it too. Money managers including Ashmore Group Plc and Prudential International Investments Advisers LLC said the passage of the levy will boost the attractiveness of India’s stocks and bonds.

But any near-term inflation hit carries risks. Cost surges in staples such as onions or potatoes can sway sentiment among the poor. Rising prices ahead of the 2014 general election soured voters on the then-ruling Congress party and helped catapult Modi’s party to the first parliamentary majority in 25 years.

Former Finance Minister Palaniappan Chidambaram, who proposed the first GST bill in 2006, on Wednesday urged Jaitley to cap the GST at 18 percent to avoid inflation pressures. Finance Secretary Ashok Lavasa told reporters on Thursday that there would be no overall impact on inflation if the rate is no higher than 20 percent.

"To implement the GST is a headache," Jaitley said in his final response to lawmakers, invoking laughs. "To be a former finance minister is a luxury."

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