India: Tax Reform Paves the Way for Investment Opportunity
Global Equity Team Perspectives by Nick Niziolek, CFA
August 31, 2016
We have long viewed expanding economic freedoms as one of the most powerful catalysts for economic growth and investment opportunity. Economic freedoms—such as private property rights, reasonable taxation, transparent markets and accounting practices—encourage capital flows and entrepreneurship and in turn contribute to higher sustainable growth.
Economic reforms often take years to become fully entrenched, but we believe a number of emerging economies are reaching meaningful inflection points. Our view is that we can add significant value over time by identifying, understanding, and investing behind the positive inflection points created by economic reforms. This post introduces a series of emerging markets spotlights where we see signs of encouraging inflection points, beginning with today’s post on India.
Earlier this month, India’s Upper House of Parliament approved a new and greatly simplified goods and services tax policy (GST). Currently, the central government taxes services and the production of goods, while state governments tax goods at the point of sale. Localities also levy an array of taxes, with local collection making logistics slow, expensive and unreliable. Tax costs “cascade” along the value chain, pushing up both costs for manufacturers and prices for consumers. Meanwhile, states and localities are incentivized to offer tax exemptions that spur manufacturers to locate to areas where production otherwise makes little economic sense.
The new GST would replace a slew of central, state, and local taxes with a unified tax levied on the final user. The underlying principle of the GST is taxing goods at the point of consumption rather than through the production chain. Indeed, the GST represents the biggest change to Indian tax structure since the country’s independence in 1947. Although the short-term impact of GST may be muted, some reports suggest that GDP growth could be boosted by 1 to 2% per year over time.
More specifically, the GST provides a potential:
Fiscal boost. Reduced tax evasion and a reduced number of tax-exempt goods could lead to increased government revenues, which in turn could be directed into a range of investments to strengthen the country over the long term, such as schools and infrastructure.
Productivity boost. Goods should move more efficiently across state boundaries as state and localities would no longer be able to charge their own taxes. This creates a level playing field for manufacturers to set up where it is economically efficient to do so.
Investment boost. The GST is likely to lower cost of capital good products throughout India. With lower taxes, it will be cheaper to ship goods from state to state versus importing them from outside India. If implemented properly, the GST represents a step in turning Prime Minister Modi’s “Make in India” vision into a reality.
Consumption boost. The overall cost of manufactured goods should be lower, while the e-commerce industry should be much less constrained by state restrictions and local levies.
The bill still needs to be passed in the Lower House of Parliament, but we see this as an extremely high probability given that Modi’s backers hold the majority within that House. Then, more than 50% of India’s states need to ratify the legislation, which could happen over the next few months. Then, there needs to be some further hammering out of the details related to structure and tax rates, and there will be a range of infrastructure demands (accounting systems and government software). Even so, the GST could come into force as early as spring of 2017.
Investing Alongside the GST Inflection Point
Our Global Equity Team has identified a number of Indian companies that we believe can benefit from the GST. While these companies represent a broad group of industries, they derive the majority of their sales from within India, and some are beneficiaries of more than one GST “boost.” These include:
An engineering and construction company (fiscal boost and investment boost beneficiary), positioned to capitalize on Modi’s focus on infrastructure build out, with recent order growth driven by increased spending on transportation, schools, hospitals, power generation and defense.
Large household products and tobacco producers (consumption boost beneficiaries), growth prospects that can be supported by increased consumer spending as the simplified GST lowers the cost of goods.
A large oil refiner/marketer (fiscal boost and consumption boost beneficiary), where we see opportunities tied to an expected increase in demand for refined fuel products. In terms of the fiscal boost, this company can profit from infrastructure buildout and manufacturing tied to the “Make in India” initiative. There’s also a tie to the consumption boost, as auto sales are likely to rise with the passage of the GST.
Retail-focused and corporate-focused private banks (productivity boost and investment boost beneficiaries). Amplifying the tailwinds of strong demographic trends and currently low banking penetration levels, reform momentum should lead to further loan growth as Indian businesses seek capital and entrepreneurship within the country increases.
Over recent years, we have seen many reforms in India that are increasing positive sentiment and our outlook for the country’s economic prospects. We view the GST as a major reform in a line of reforms that is fueling and broadening the recovery in the Indian economy. Assuming the GST moves forward as we expect, we believe companies across industries will enjoy stronger tailwinds for sustainable growth.