Balancing Reform and Reality: The GST Dilemma for MSMEs

Introduced in 2017, the Goods and Services Tax (GST) was envisioned as a transformative reform to unify India’s complex taxation system under the banner of ‘One Nation, One Tax.’

For India’s Micro, Small, and Medium Enterprises (MSMEs), GST has been a double-edged sword, presenting both opportunities and challenges. While the system has simplified tax processes for some, many MSMEs continue to grapple with compliance complexities, increased costs, and disrupted cash flows. This dual impact underscores the delicate balance between ambitious policy objectives and the realities faced by small businesses.

Two primary factors drive this tension: the formalisation of the informal economy, while boosting GST collections, has disrupted supply chains and slowed business growth due to heightened compliance burdens.

Additionally, the restructuring of supply chains under formalisation has increased operational costs, stifling the entrepreneurial spirit and hampering competitiveness of small enterprises.

With the upcoming 2025 budget, there is hope for reforms that address these persistent challenges.

With 3.16 crore MSMEs registered under GST, contributing about 30% to India’s GDP and nearly 50% of its exports, MSMEs are critical to the nation’s economic growth and resilience. As the second-largest job creators after agriculture, they employ 80% of the industrial workforce while accounting for just 20% of total investment. MSMEs bridge economic disparities with their deep understanding of local markets and adaptability, creating jobs in smaller towns and rural areas where large corporations are reluctant to invest.

Initially met with scepticism, the GST regime has seen a growing acceptance among MSMEs, though significant challenges remain. Deloitte’s GST@7 survey shows that 78% of MSMEs now view GST favourably, up from 66% in 2023. While this shift reflects increased acceptance of tax reform, concerns about compliance complexities, cost burdens, and the impact on business growth and adaptability highlight the need for further improvements.

Since its rollout, GST has had a mixed impact on MSMEs across India, with significant disparities in compliance and registration trends. States like Tamil Nadu and Karnataka have led the way in GST implementation, along with Gujarat and Maharashtra, which have created MSME-friendly environments through higher business registration rates, technology adoption, and support centres to simplify compliance.

However, states like Bihar, Jharkhand, Uttar Pradesh, Chhattisgarh, and parts of the Northeast continue to lag, with compliance and registration rates as low as 40-50%. These regions face challenges such as limited technological access, inadequate infrastructure, and overly complex regulations, leading to increased operational costs and barriers for small businesses. In a positive development, the GST Council has proposed reducing the Tax Collected at Source (TCS) rate for e-commerce operators from 1% to 0.5% in 2024.

This aims to ease working capital pressures on MSMEs reliant on e-commerce platforms, enhancing their cash flow and enabling reinvestment for growth. Despite these efforts, MSMEs in lagging states continue to face high costs and technical complexities, underscoring the uneven impact of GST. Overcoming these disparities demands state-specific interventions to address gaps in infrastructure, technology, and support systems. Such targeted efforts are essential to ensuring GST drives inclusive growth and empowers MSMEs across the country.

First, the GST regime presents significant challenges for MSMEs, stemming primarily from the complexity of multiple tax slabs and the disproportionate tax burden. One example is the “inverted duty structure,” where MSMEs manufacturing spare parts for large automobile companies and other industries face an 18% tax rate, while the finished product, such as a tractor, is taxed at just 12%. Such disparity places MSMEs in a disadvantageous position, exposing them to potential exploitation and financial strain.

Moreover, MSMEs are initially exempted from paying GST up to a turnover of Rs 40 lakh, the challenges begin once they cross this threshold. Upon becoming eligible to pay the standard 18% GST rate, their effective income drops to Rs 32.8 lakh – a reduction of Rs 7.2 lakh. This significant deduction not only strains their financial stability but also hampers their ability to reinvest, expand and creates a growth ceiling; curbing their entrepreneurial potential and the vision of a simplified tax system.

A balanced GST structure is essential to bridging the gap between MSMEs and the larger companies they supply. For instance, instead of MSMEs paying 18% GST on spare parts while larger firms pay 12% on finished products, a unified middle-ground rate of 15% could promote fairness. Furthermore, consolidating GST slabs into three categories – 5%, 15%, and 28% – could streamline compliance, reduce complexity for MSMEs, and ensure uniformity across industries. This restructuring would simplify the tax framework, making it more accessible for smaller businesses while maintaining revenue neutrality (see table below).

This approach could streamline tax compliance and ensure a more equitable distribution of the tax burden. Additionally, such measures could build trust between MSMEs and larger enterprises, fostering stronger collaboration and a more efficient supply chain.

Second, filing tax returns on the GST portal has been fraught with inefficiencies, often resembling a trial-and-error approach. Despite efforts to digitise and streamline the taxation process, technical glitches in the GST portal remain a persistent issue. For instance, large companies reliant on supplies from MSMEs must wait up to four months to claim tax benefits. To expedite this process, these larger players often withhold payments to MSMEs, depriving them of essential working capital. Additionally, MSMEs are pressured to file monthly GST returns to facilitate quicker claims for their clients. This not only undermines the intended simplicity of GST but also adds unnecessary compliance costs, further burdening MSMEs.

Moreover, GST compliance imposes significant challenges for MSMEs. Businesses with an annual turnover exceeding Rs 7.5 million face stringent requirements to collect and report transaction-wise data on the electronic portal. Exporters, previously exempt from input taxes, must now pay taxes upfront and claim refunds post-filing, straining their working capital. Additionally, exporters without a letter of undertaking or bond must collect taxes on exports as if they were domestic sales. Informal and marginal businesses, burdened by new tax obligations and compliance costs, risk closure, potentially causing a ripple effect throughout the value chain.

In this context, one potential solution could be to mandate MSMEs raising invoices after receiving cash payments from these larger companies, rather than on an accrual basis. This would ensure better cash flow management for MSMEs and prevent undue financial strain caused by delayed payments. Additionally, the practice of forcing MSMEs to file returns on a monthly basis could be alleviated by introducing a provision that allows quarterly filings. This adjustment would reduce the compliance burden on small businesses, giving them more flexibility to focus on their operations rather than grappling with frequent paperwork.

Let us not overlook that the GST portal itself also requires significant improvements to better support MSMEs. For example, instead of forcing businesses to refile an entire return due to a minor error, the portal should include user-friendly options to correct mistakes directly. Clearer rules, coupled with an efficient digital infrastructure, would enhance compliance rates while alleviating the financial and administrative burdens that currently hinder MSME growth. 

Though GST has streamlined taxation and boosted revenue collection, challenges like increased compliance costs, supply chain disruptions, and burdens on small enterprises have hindered its welfare impact. For many MSMEs, these issues have stifled growth, exposing gaps in policy design and implementation.  India’s experience echoes global challenges with similar reforms. Malaysia, for instance, repealed its GST in 2018 due to public dissatisfaction and adverse effects on small and medium businesses. In contrast, the European Union’s VAT system has succeeded by incorporating tailored exemptions and subsidies to support smaller enterprises. The 2025 budget presents a vital opportunity to address MSME challenges and expectations. Key demands include technological integration, such as linking the GeM portal to Udyam registration for better market access, a Technology Upgrade Fund for industries beyond textiles, and GST exemptions for recycling machinery to support sustainability. Simplifying the GST framework – by merging tax slabs, introducing faceless audits, and reducing compliance costs – is another priority. Stakeholders also call for incentives to foster innovation in renewable energy and AI while easing the tax burden on small businesses. A balanced approach of regulatory reforms, fiscal relief, and targeted investments can empower MSMEs to drive innovation, employment, and economic growth.

Vrinda Mandovra is a student of economics honours at FLAME University, Pune. Rituparna Kaushik is an assistant professor of economics at FLAME University, Pune. All views expressed are personal.