After Friday’s GST Council meeting, which decided to cut the goods and services tax rate on two dozen commodities and announced relaxations for exporters and small and medium companies, Prime Minister Narendra Modi said the changes brought in an early Diwali.

The business press was bullish as well. “Three months on, GST now good for small traders,” said one headline.

This ebullience is intriguing. The impact of the Goods and Services Tax is complicated. Billed as India’s biggest tax reform, GST subsumes all the indirect taxes that businesses earlier paid the Centre and states separately with the aim of creating a common market. It involves a complete overhaul of the tax filing system.

Since its implementation on July 1, as several articles in and other publications have shown, small and medium companies in a range of industries are struggling to stay viable while complying with the new tax regime’s requirements. That is not all. GST also affects different companies in the same industry in different ways. For both these reasons, the GST Council’s revisions on Friday deserve a closer look. How far do they go? Do they really address the major concerns of all Micro, Small and Medium Enterprises, also known as MSMEs, in the country?

A tale of two clusters

Seeking answers, spoke to business owners in two manufacturing clusters – Hosur and Surat. Hosur, located in Tamil Nadu, close to the state’s border with Karnataka, is best known for automotive components and granite. Surat, located in South Gujarat, is India’s largest producer of manmade fabrics.

Both clusters differ in important ways. The businesses in Surat are predominantly informal. The vast majority of its manufacturing units are tiny. Housed in a room or two, they specialise in one or two stages of, say, sari manufacturing like weaving, printing or embroidery. Coordination between these units is handled by Surat’s 70,000 textile traders. In contrast, Hosur’s value chain is far more organised. Most auto-engineering units here serve one of the town’s two big manufacturers – Ashok Leyland and the TVS Motor Company.

Manufacturing and trading businesses in these two clusters are a fairly representative slice of India’s Micro, Small and Medium Enterprises sector.

How GST has affected Hosur

On the day the GST Council convened, met V Gnanasekaran, the president of Hosur Small and Tiny Industries Association. Most of its members are small units supplying components to tier one and tier two suppliers of Ashok Leyland and TVS. (In the automative industry, tier one firms are those that directly supply to automotive companies, while tier two firms are the key suppliers to tier one suppliers.) How has GST affected them?

According to Gnanasekaran, whose company makes sheet metal components for TVS, the association’s members have been hit by GST in three major ways. For one, their tax burden has spiked. As the chart below shows, if a unit bought steel worth Rs 1 crore, it paid a tax of Rs 4.3 lakh under the previous Value Added Tax and excise regime. Under GST, it has to pay Rs 17 lakh.

Note: Landed price is the total price, including all taxes, freight and insurance fees.

This is a problem. Given high competition, these units work on thin margins. The net margin on that Rs 1 crore order is no more than 2% (Rs 2 lakh) if a unit is working at 100% capacity, said K Velmurugan, the treasurer of the association. The higher tax burden takes away almost all the net profit. At the same time, this added cost cannot be passed onto customers, again due to high competition.

Ashok Leyland and TVS had set up plants in Hosur in 1978, when several other industrial estates were coming up in the area. Forty years later, their units are still the principal factories in the town but, as Gnanasekaran said, the number of ancillary units feeding them has grown from 150 to 5,000. This means that they have limited room to increase prices. As Gnanasekaran said, “Customers [Tier one and tier two suppliers to Leyland and TVS] can keep shifting from supplier to supplier.” This competitiveness is one reason why units like his had welcomed GST. He said we thought “the price of raw material will go down”.

Units like his have been hit by GST in two other big ways. The first of these is working capital. GST has to be paid – not when a company receives its payment from the customer – but after the sale is made. When Gnanasekaran makes a sale, he factors in the 28% GST into his sale price. He has to report this transaction during his next GST filing and pay the tax. But the catch is that customers take as long as 100 days to pay him (in accounting parlance, this is known as a credit period). This means that he has to pay the tax out of his pocket. This means that working capital requirements for him – and units like his – have gone up steeply after the introduction of GST.

Velmurugan elaborated this point. He said that a company with an annual turnover of Rs 10 crore will need about Rs 2 crore as working capital. Thus, for a monthly order of Rs 1 crore, the tax payable is Rs 17 lakh. If a micro, small and medium enterprise has to pay that tax out of its own pocket for three months, the amount works out to an additional Rs 51 lakh.

This is a problem because all units do not have the resources to raise that kind of money internally – all the more because, as in the rest of India, Hosur’s Micro, Small and Medium Enterprises have been struggling over the last five years or so. Thus, to pay the tax, they need to borrow money, an added expense. “We used to take working capital loans to run the company,” said Gnanasekaran. “Now we are taking working capital loans to pay taxes.”

The third problem is entirely unexpected.

Under GST, a company can claim input credit – a reduction in the tax paid on the output, equivalent to the tax paid by previous rungs in the value chain. As the chart above showed, a company that has to pay Rs 35 lakhs as GST can tell the government that its suppliers have already paid Rs 18 lakh as tax earlier – and that its tax payable is now just Rs 17 lakh.

However, Gnanasekaran said that units like his are struggling to claim input tax credit when they source raw materials or other inputs from other states. They are asked to prove that the input tax credit has indeed been paid. While that scrutiny goes on, in order to avoid defaulting, these units are asked to pay the full GST amount anyway (Rs 35 lakh). According to Gnanasekaran, this is because states are trying to protect their local manufacturing units. Another reason could be their desire to maximise tax collections under state GST – which stay with the state government.

This is important. Not only does this development have large implications for manufacturing units – their ability to buy from and sell in other states might be curtailed if this trend grows – it also suggests that state protectionism might be a fallout of GST. The managing director of a sari-making business in Surat, who spoke on the condition of anonymity, agreed. If other states follow this too, it will be a big problem for India itself, he said.

(Photo credit: AFP).

The view from Surat

In the last six months, no town in India has protested more strenuously against GST than Surat.

The reasons run deep. Small units in the cluster are unsure if they can stay viable after paying GST – which charged an 18% tax on yarn and a 5% tax on subsequent value addition. Such units are also apprehensive about the paperwork involved – and the penalties for non-compliance. Officials at the town’s textile association flag other concerns. Surat houses two competing value chains for sari manufacturing. There is the informal economy value chain where garments whiz between diverse companies as they move from one stage of completion to the next. This is a thicket of small companies. Surat is estimated to have as many as 50,000 weaving units alone.

The other value chain, as this article on Surat’s worries about GST reported, is vertically integrated. No more than 10 or so companies occupy this space. These companies, far larger than the ones in the informal economy, buy yarn from outside but do the rest of the production inhouse. The textile association’s worry is that under GST, the informal value chain gets taxed at more points than the vertically-integrated one. Between the low economies of scale of these units plus the GST on brokers, the informal value chain will end up paying as much 20% more tax than the vertically-integrated companies. In a business with wafer-thin margins, this moves competitive advantage towards larger units.

That said, larger units in Surat were unhappy too. A big reason is input tax credit. Under the GST regime, tax is not levied at the end of the production process but at every step along the chain. If a company buys polyester yarn for Rs 1,000 and sells the finished garment for Rs 1,800, it only has to pay tax on the Rs 800 of added value. If the company pays more than what it needed to, it can recover the balance from the government when the buyer of the garment pays tax. As this explainer points out, the surplus can be claimed as a refund, or used against future tax payments.

But this is not how things are working in practice.

Take the company buying polyester yarn at Rs 1,000 and selling the finished garment at Rs 1,800. It has to pay 5% GST on Rs 800 – the value it added by turning the yarn into a garment – which works out to Rs 40. The catch is that while the finished garment attracts GST of 5%, polyester yarn is taxed at 18%.

As the managing director of the sari-making company had explained in an earlier report on GST’s early impacts on Surat, when he buys yarn worth Rs 1,000, he pays Rs 180 as tax (at 18% GST). Since he should have paid only Rs 40 as tax (at 5% on the value added of Rs 800), he is entitled to a refund of Rs 140. However, when he sells the finished product at Rs 1,800, the company buying it pays 5% as GST, or Rs 90. So, the maximum tax refund he can get is Rs 90. “The government will keep the rest of the money,” he said. “The customer will have to buy a costlier sari, and the industry will take a hit.”

(Photo credit: PTI).

The story of expectations

All this together explains why each of these units is desperate for relief with regard to GST.

What underscores the urgency is this: each of these units is already in trouble. Micro, Small and Medium Enterprises in Gujarat are already in crisis mode. Things are no different in Hosur. In the last five or six years units have begun selling out, said Gnanasekaran. A businessman in Hosur, who spoke on the condition of anonymity, said he sold his industrial plot as liabilities rose. He has now signed away his house as collateral to a bank. And now, after the introduction of GST, liabilities are rising again.

If these are the problems, what are the reliefs these units seek?

In Hosur, the manufacturing Micro, Small and Medium Enterprises want the government to maintain the same tax level for input and output for intermediate processors like auto-component makers. They also want the government to ensure their customers pay them faster. They were also unhappy with the Rs 20 lakh threshold for GST exemption, saying that it is too low.

Hosur’s wholesalers and shopkeepers are struggling as well. As with the manufacturing companies, credit periods have lengthened from 15 days to two to three months. At the same time, businesses paying GST are struggling to compete with unorganised sector rivals who are not, said A Thomas John, head of the Hosur Traders Association. “We had welcomed GST thinking that all businesses will move to pucca [the formal economy]” he said. That is not happening. Enforcement needs to improve. At the same time, he said, GST has too many slabs.

In Surat, smaller units want lower taxes or full GST exemption. The industry association wants the government to take a relook at the tax slabs for the industry – to fix their input credit problem. There too, units say they prefer lower taxes because that will spur tax compliance.

Did Friday’s GST revisions help?

Given this backdrop, how do the GST Council’s recommendations stack up?

None of the manufacturing Micro, Small and Medium Enterprises concerns – tax slabs, working capital and input tax credit – have been addressed. In contrast, Surat’s concerns have received more attention. On Friday, the GST Council said that units with a turnover up to Rs 1.5 crore can file their returns every quarter instead of every month. It also slashed the tax rate on yarn from 18% to 12%.

In Surat, reactions to this are mixed. Prakash Gandhi, an independent chartered accountant who works with small units, said the relaxation on filing returns, will come as a relief for his customers. “They will still need to maintain their books of accounts but that fear of the daily financial penalty – if they missed a return – is no longer there,” he said.

Others, like the managing director of the sari manufacturing company, were harsher. “There might be a relaxation on returns’ filing but those units will still have to pay their taxes every month,” he said. The managing director added that the council’s decision benefits very few companies. “Most businesses in Surat are above Rs 1.5 crore in turnover,” he said.

And what about the drop in GST for yarn?

“That will help some units,” said the managing director. “It is good for a mature unit which has depreciated its machinery.” A new unit, which has to collect input credit on new machinery it has bought, he said, will find what gets collected from end-customers insufficient. This is especially critical because, as has reported, industries in Surat are currently adding scale in a bid to survive.

On the ground, things seem bleak. “Out here, people are losing jobs,” said Thomas of the Hosur Traders Association. “There is no real GDP growth at all.” And so, the government’s unresponsiveness is resulting in disenchantment. Referring to the reduction in GST on the Gujarati snack, khakra, from 12% to 5%, Thomas said: “It is a mockery. It is an eyewash. I am not sure if…the government is promising only on screen or in reality.”

Velmurugan agreed. “I do not like the Congress because they do minority appeasement,” he said. “But this government is killing our businesses.”

In the meantime, the government’s statements about the GST revisions has led to anger.

Jayaramaiah runs a hardware store in Bagalur, about 20 km from Hosur. This correspondent first met him last November while reporting on demonetisation. At that time, Jayaramaiah, a BJP supporter for 25 years, had supported the move. But this time, he was angry. “The papers say we will be a bigger economy than Japan and Germany in 10 years,” he said. “But what about my today? Do I sleep hungry tonight because I have been promised a big meal tomorrow?”