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India Goes Big to Lure Foreign Investment

Aug 10, 2016
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SMITH BRAIN TRUST — Foreign firms entering India to do business are "entering essentially 29 different countries," says professor Kislaya Prasad at the University of Maryland's Robert H. Smith School of Business. That’s because tax systems differ state to state in a market otherwise attractive — especially for U.S. companies — with a democratic government, large economy and skilled workforce that largely speaks English. Trucks in long lines at state borders waiting for inspection and to pay duties is one common sign of the inefficiency. But a revamping looms. In what has been hailed as the most significant reform effort since 1991, India’s Parliament on Monday approved a goods and services tax that streamlines the system.

“It’s potentially a big deal for U.S. companies,” says Prasad, research professor and director of the Smith School's Center for International Business Education Research. “I say potentially, because at least half of India’s state legislatures must ratify the constitutional amendment." This includes agreeing on uniform tax rates. If a government panel-suggested 18 percent rate (below the current rate on manufactured goods, but above that on services) carries, “manufacturing, especially in the automotive sector, could see a substantial boost,” he says.

India officials aim to enact the measure as soon as April 2017. Prasad describes it as a value-added tax on goods and services, replacing a large number of indirect taxes levied at the federal, state and local levels, and introducing considerable uniformity. “GDP growth over three to five years is expected to range from 0.5 percent to 2 percent and attract foreign investment," Prasad says. "Efficiency gains, especially in logistics, would be fairly immediate.”

Keeping it simple

The measure's most immediate benefit would be reducing complexity, especially for businesses that operate in multiple states. “More significantly, the value-added tax means businesses pay tax only on the value they create, and not the full value of the good,” Prasad says. This means companies would be “rebated taxes paid at previous stages of the value chain, which serves to eliminate a compounding effect of tax on tax,” he says. “Subsequently, the effective tax rates, especially on manufacturing goods, are excessively high.”

The measure also could eliminate interstate commerce tax inefficiencies. Industrial producers often maintain warehouses in each state to handle sales within the state to avoid this tax. “Smaller producers that cannot do so find themselves at a competitive disadvantage,” Prasad says. "This also would eliminate the truck lines and be especially attractive to those smaller companies, which may have hitherto been dissuaded by the complexity of operating in India.”

Boosting transparency

Tax compliance is another benefit. By reporting a transaction, like a purchase from a supplier, the buyer can rebate the taxes paid. “This increases the incentive to conduct transactions in the open,” Prasad says. A faster-growing economy would benefit all sectors, but some more than others. An auto manufacturer such as Ford, with a manufacturing facility near Chennai, would benefit more in the short run than a financial services company. Despite slightly higher rates of taxation, e-commerce companies such as Amazon would generally find the reforms to be beneficial, especially because hindrances from restrictive rules and taxes imposed by states on e-commerce would be eliminated. 

A caveat?

Smith School professor Peter Morici told the BBC that states individually might look for ways to circumvent a streamlined system to protect local enterprises. This would be avoidable, he says, by incorporating “use taxes” among other tax measures seen at the U.S.-state level. But Prasad says the scope of corruption at India’s state level should go down because any discretion that states have on levies would be curtailed. “Typically it is the discretionary powers that create the opportunity for corruption,” Prasad says. “And with tax compliance likely to increase, U.S. firms will have comfort in knowing that their competitors are not availing of unfair advantage by avoiding taxes.”



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