Ajit Ranade: India’s budget should sort out GST’s input tax credit system to perk up private investment

There are several reasons for this, including the cost of capital and still-muted animal spirits. But one underappreciated reason lies in the design of the goods and services tax (GST), particularly its treatment of capital goods.

One powerful reform in the forthcoming budget to revive private investment would be to place capital goods squarely and cleanly within the GST framework, with full, immediate and usable input tax credit (ITC).

GST is a destination-based value-added tax on final consumption. It is not meant to be a tax on production or investment. Its logic rests on seamless input tax credit. Taxes paid on inputs—whether consumption goods, services or capital equipment—should flow through the value chain and never become a cost to business.

But in practice, due to ITC delays and the near-impossibility of monetizing ITC on capital goods, India’s neutral consumption tax has become something like a tax on production and investment. Capital goods—machines, plant, equipment and construction inputs—often generate large GST credits that remain trapped for years, sometimes indefinitely. This raises the cost of capital.

To be sure, ITC on capital goods exists under the GST rules, but only on paper. Its real economic value is limited. While late tax refunds on exports and inverted duty structures can trap capital, capital-intensive service sectors are explicitly kept out of ITC claims on capital goods.

Firms gather credits that can’t be used, even though they have paid the tax. This raises the effective price of investment. When GST paid on machinery or construction cannot be recovered in cash or set-off smoothly, it gets embedded in the project cost. A tax that was meant to be neutral quietly turns into an investment tax.

It also has a cascading effect. Once unrecovered GST becomes part of the cost, it is taxed again at the next stage. Even a modest denial of ITC can push effective tax rates far above the statutory rates, distorting prices, margins and competitiveness .

Further, it biases production decisions away from capital expenditure, scale, technology and formalization. Firms might delay capacity expansion or structure supply chains to minimize ITC loss rather than maximize business gains.

Capacity utilization has improved, but greenfield private investment is hesitant. Infrastructure is being built largely by the state, whose fiscal capacity is limited. Private investment spending is critical for growth. By taxing investment inputs, the GST system discourages factory expansion, technology adoption and thus productivity growth.

When China converted its value-added tax (VAT) into a full consumption-type tax by allowing full credit and refunds on capital goods, firms experienced significant productivity gains.

A common objection is that allowing full ITC on capital goods will create an overlap or misuse because firms also claim depreciation under the income tax rules. But this confusion stems from mixing two different tax bases.

The GST is a consumption tax whereas income tax is a levy on income. Capital goods must be treated as intermediate inputs under GST, not as final consumption.

The principle is straightforward: either allow ITC under GST or depreciation under income tax. Many VAT systems globally handle this by disallowing depreciation on the GST-credited portion of capital costs. India does this in law; the problem lies in incomplete GST credits.

Using a flawed GST design as a substitute for income-tax enforcement is economically costly and intellectually incoherent. Last year’s GST slab reduction and rate rationalization were welcome, but these alone can’t revive investment. Lower GST rates with blocked credits create distortions. A GST rate of even 18% with full ITC credit would be much better than a lower rate riddled with exclusions.

A recent paper by Arbind Modi and Ajay Shah persuasively argues for this reform claiming that it can raise growth by 0.3 to 0.7 percent. When buyers cannot claim credit, they have little incentive to insist on invoices. This erodes the audit trail and pushes the system towards informality—the opposite of the self-compliance it was meant to achieve.

The next Union budget should first aim to guarantee full and immediate input tax credits on capital goods, including refund eligibility should credits accumulate. Capital goods should be treated as intermediate inputs and not as final consumption goods.

Second, it should rationalize refund rules so that excess ITC—whether arising from exports, inverted structures or capital-intensive production—is refunded automatically, with post-audit safeguards rather than ex-ante denial.

Third, the budget should align GST with income tax rules by disallowing depreciation on the GST-credited portion of capital spending.

None of this requires fiscal recklessness. Denying ITC on capital goods is depressing investment, productivity and compliance. International experience shows that neutral VAT systems are more buoyant, not less.

This is a big reform hiding in plain sight, with little political cost. Fixing GST’s treatment of capital goods would lower the cost of capital, raise productivity and support exports. It will contribute greatly to reviving India’s investment cycle.

The author is senior fellow with Pune International Centre.