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Tax Increase Forces Financial Services in India to Adjust

September 20, 2017

By CJ Novogradac

The Goods and Services Tax (GST) implemented this past June is the largest tax reform in India’s history. By creating a federal taxation system, the GST has major implications for the economy as whole and financial services in particular. Though the expected boost to economic growth will benefit financial services, the GST also involves switching costs, a 20 percent tax increase, and further uncertainty as to future tax changes.

Enacted through a constitutional amendment, the GST establishes four common tax brackets applicable across all 29 Indian states covering most goods and services. Previously, Indian businesses were exposed to an array of different tax rates across the various states. The Indian government hopes the GST will reduce inefficiencies in the tax system and lay the bedrock for future growth.

Under the GST, taxes are levied every time a good is sold or service is provided on a value-added basis.  For example, taxes are paid when a manufacturing company sells to a wholesaler, again when the wholesaler sells to a retailer, and once more when the retailer sells to the end consumer. The proper classification of each particular good and service is crucial to maintaining the integrity of such a tax reform.

All businesses feel the effects of the reform, directly through increases in tax rates on their goods and services, or through indirect price increases in the broader economy. According to a World Bank analysis, the anticipated increase in competition and reduction in inefficiencies associated with the current tax structure will outweigh any drag on activity caused by higher taxes. Goods and services, for instance, will now travel more easily across state lines, only paying a flat tax, eliminating the inefficient delivery mechanisms often used by businesses to arbitrage tax rates among the states.

For financial services, the GST brings a host of challenges, including an increase in effective taxes, operational expenses, the cost of revenue recognition, and uncertainty to the future tax treatment of interest income. First, financial institutions will see a 20 percent increase in taxes, as the tax rate ratchets up to 18 percent from 15 percent. While banks are expected to pass some of the higher taxes onto customers, they will likely bear a portion of the cost.

The cost of implementing the new tax regime will affect the business operations of all financial institutions. Under the GST, institutions must register in all states they do business in, posing a challenge to many national banks. Banks commonly offer unique services located in many or all of India’s 29 states, forcing banks to register and maintain certification in the applicable states.

Banks also face a new dilemma surrounding revenue recognition. Each firm must know where a service was provided so that the federal government can send the associated tax revenue to the state where the transaction took place. Given that financial services are often virtual, the change forces banks to move from centralized compliance to state-based compliance systems, creating ripple effects in financial products and IT systems. Some banks have branches in all 29 states, including remote and rural locations, making the attribution of revenue a complex challenge. These banks will have to create systems that will efficiently trace revenue to the location of the consumer and successfully relay this information to the government, a task that could prove time-consuming and costly.

Like the demonetization last year, the challenge of adopting to the new system may ultimately lead to advances in the adoption of new technology in the financial sector. The indirect mandate to create a locating system for points of consumption may lead to the creation of financial technology that has ancillary benefits for banks. For instance, such financial technology may allow banks to supply their services through a mobile app rather than through a physical bank. Some Indian banks have already invested significant resources into modernizing their back office systems, which will provide opportunities for improving the level of technology throughout the entire organization.

The introduction of the GST seems to have had a muted impact on banks. However, only time will tell how the new system will affect the financial performance of these institutions. Investors seem to be paying more attention to the positive impact of the reform on the overall economy. Over the next several months, banks and the Indian economy as a whole will face significant switching costs associated with converting to the new tax system. In the long run, the benefits from replacing the previous unwieldy tax system with a simpler structure will greatly reduce the many costs associated with a complex tax system, resulting in a new system that is beneficial to all.

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CJ Novogradac

was an intern in the Financial Institution Supervision and Credit (FISC) Division of the Federal Reserve Bank of San Francisco.