Budget Must Address GST Input Tax Credit to Revive Private Investment
India faces a puzzling economic situation today. The country's GDP growth ranks among the world's fastest. Public capital expenditure has increased significantly. Corporate balance sheets show better health than they have in years. Yet private investment remains sluggish, especially in manufacturing capacity, machinery, and factory expansion.
Several factors contribute to this investment hesitation. The cost of capital plays a role. Business confidence could be stronger. However, one overlooked reason lies within the design of the Goods and Services Tax itself. Specifically, the tax treatment of capital goods creates significant problems.
The GST Problem with Capital Goods
GST operates as a destination-based value-added tax on final consumption. It should not function as a tax on production or investment. The system relies on seamless input tax credit flow. Taxes paid on inputs should pass through the value chain without becoming a business cost.
In practice, this ideal breaks down. Delays in input tax credit and difficulties monetizing credits on capital goods transform India's neutral consumption tax. It effectively becomes a tax on production and investment activities.
Capital goods like machines, plants, equipment, and construction materials often generate substantial GST credits. These credits frequently remain trapped for years, sometimes indefinitely. This situation raises the effective cost of capital for businesses.
How Blocked Credits Hurt Investment
Input tax credit for capital goods exists in GST rules on paper. Its real economic value remains limited. Capital-intensive service sectors face explicit exclusion from claiming these credits. Firms accumulate credits they cannot use despite having paid the taxes.
When GST paid on machinery or construction cannot be recovered smoothly, it embeds itself into project costs. A tax designed to be neutral quietly turns into an investment tax. This creates a cascading effect throughout the economy.
Once unrecovered GST becomes part of a product's cost, it faces taxation again at the next stage. Even modest denial of input tax credit can push effective tax rates far above statutory rates. This distortion affects prices, margins, and overall competitiveness.
The system biases production decisions away from capital expenditure, scale expansion, technology adoption, and formalization. Companies might delay capacity expansion or structure supply chains to minimize input tax credit loss rather than maximize genuine business gains.
The Reform Solution
The forthcoming Union budget presents a powerful opportunity. Placing capital goods squarely within the GST framework with full, immediate, and usable input tax credit could revive private investment significantly.
China's experience provides a relevant example. When China converted its value-added tax into a full consumption-type tax by allowing complete credit and refunds on capital goods, firms experienced notable productivity gains.
A common objection suggests allowing full input tax credit on capital goods might create overlap with income tax depreciation claims. This confusion stems from mixing two different tax bases. GST functions as a consumption tax while income tax levies income.
The principle remains straightforward. Either allow input tax credit under GST or permit depreciation under income tax rules. Many global VAT systems handle this by disallowing depreciation on the GST-credited portion of capital costs. India's law already contains this provision. The problem lies in incomplete GST credits in practice.
Specific Budget Recommendations
The Union budget should pursue several concrete reforms:
- Guarantee full and immediate input tax credits on capital goods, including refund eligibility when credits accumulate.
- Treat capital goods as intermediate inputs rather than final consumption goods within the GST framework.
- Rationalize refund rules so excess input tax credit receives automatic refunds with post-audit safeguards instead of ex-ante denial.
- Align GST with income tax rules by disallowing depreciation on the GST-credited portion of capital spending.
These reforms would not require fiscal recklessness. Denying input tax credit on capital goods currently depresses investment, productivity, and compliance. International experience demonstrates that neutral VAT systems prove more buoyant, not less.
This represents a significant reform hiding in plain sight with minimal political cost. Fixing GST's treatment of capital goods would lower capital costs, raise productivity, and support exports. It could contribute substantially to reviving India's investment cycle at a critical economic moment.
