The Problem: Stuck Input Tax Credits
Industry groups, led by Empower India and its Director General K. Giri, are urging the government to resolve persistent issues within India's Goods and Services Tax (GST). The main problem lies with the 'inverted duty' structure (IDS), where tax rates on raw materials, services, and capital goods are higher than the output tax rates on finished products. This mismatch results in businesses accumulating large amounts of unutilized input tax credit (ITC). This trapped ITC blocks crucial working capital, severely impacting Micro, Small, and Medium Enterprises (MSMEs) that operate on tight budgets. Although significant GST 2.0 reforms were introduced recently to address such tax disparities, the issue remains. Empower India highlights that refunds for input services and capital goods are still excluded under Section 54(3) of the CGST Act. This restriction prevents businesses from recovering legitimate tax credits on essential operational expenses, creating a major hurdle and undermining the GST's goal of tax neutrality.
Economic Impact: Demand and Manufacturing Slowdown
This ongoing problem of blocked working capital is hitting India's economy at a critical time. Manufacturing activity, measured by the HSBC India Manufacturing PMI, recently fell to 53.8 from 56.9 in the preceding month, marking its weakest reading since September 2021. This slowdown is linked to weaker domestic demand and rising uncertainty from Middle East conflicts, which also increased input costs. Consumer sentiment saw a slight rise in the latest surveys, but underlying data shows financial strain for everyday spending and non-essential purchases, indicating caution and potentially lower demand. In this scenario, failing to fix the inverted duty structure and ensure efficient ITC refunds directly counters efforts to boost domestic consumption and manufacturing. Sectors like MedTech, where input GST is 18% but finished devices are taxed at 5%, face severe working capital shortages, with refunds from previous rate changes still pending. Similarly, FMCG companies often pay 18% GST on key services like transportation and marketing, while their final products are taxed at 5%. This wider gap traps more liquidity. Recent GST 2.0 reforms, while simplifying rates, have unexpectedly worsened these issues in some supply chains as many finished goods moved to lower tax brackets.
Why It Hurts MSMEs Most
The continued existence of inverted duty structures, especially the exclusion of input services and capital goods from refunds, is a major flaw in India's GST system. This limitation directly weakens the 'Make in India' and Production-Linked Incentive (PLI) schemes, which aim to boost domestic manufacturing and exports. It increases the effective cost of production and reduces competitiveness. Unlike regions like the European Union, where accumulated input tax credits can be refunded regardless of whether they are for goods, services, or capital goods, India's rules are more restrictive. This puts Indian manufacturers at a disadvantage. Larger companies can often manage the cash flow strain, but MSMEs are hit hardest due to their limited resources. Studies consistently show MSMEs face higher compliance costs and liquidity problems under GST, with slow ITC refunds being a top concern. The current system effectively acts as a tax on production rather than consumption, leading to cascading effects and embedding non-recoverable taxes into costs. This persistent issue, even after recent GST 2.0 reforms, questions the system's overall efficiency and the government's commitment to a truly competitive business environment.
Hope for Reform: Proposed Solutions
Industry stakeholders hope that future policy actions, possibly discussed at the next GST Council meeting, will finally resolve these critical refund and inverted duty structure problems. Proposals considered in a recent Finance Bill suggested allowing provisional refunds of up to 90% for inverted duty structures, a move that could significantly improve cash flow for affected businesses. Ongoing efforts by groups like Empower India to amend Section 54(3) of the CGST Act and redefine 'Net ITC' signal a continued demand for systemic change. Addressing these refund complexities and fixing structural inefficiencies is considered vital for boosting GST's credibility, supporting industry competitiveness, and ensuring tax reforms translate into real economic growth and better liquidity for businesses across India.