GST reform urgency: India must mend a chain of input tax credit that’s holding its economy back

In such cases, the system resembles cascading turnover-style taxation and weakens the value-added tax (VAT) principle of seamless credit and tax neutrality. So, beyond rate adjustments, deeper structural issues remain.

The proliferation of amendments and layered restrictions has made the law increasingly intricate and compromised ITC chain integrity. Without restoring credit neutrality, simplification of rates alone cannot make GST function as a true VAT.

The Union budget for 2026-27 offered an opportunity to complete this unfinished reform. Industry had expected rationalization of the ITC framework, which remains the most distortionary feature of the current system. That opportunity was missed. The result is continued working- capital blockage, avoidable tax cascades and high compliance costs for businesses.

A well-designed GST would be a destination-based consumption tax in which business-to-business transactions are tax-neutral. Taxes paid on inputs, input services and capital goods are fully creditable against output tax, ensuring that tax is levied only on the value added and never becomes a business burden. Preventing tax cascades across the value chain preserves competitiveness in both domestic and export markets.

International experience shows that the strength of a GST lies less in its rate structure and more in the breadth of its base and integrity of its credit mechanism. Countries with minimal exclusions and seamless credit chains achieve higher revenue productivity alongside lower compliance costs. A fragmented base with blocked credits, in contrast, distorts investment and production decisions.

India’s ITC framework departs from that principle in significant ways. Multiple restrictions, conditionalities and outright denials of credit have converted what should be a pass-through tax into a cost-imposing one.

Blocked credit implies a cascade that raises production cost. For instance, GST paid on immovable capital goods is denied to service providers and restricted for manufacturers to plant and machinery. Yet, such capital goods are not ‘consumed’; they are used to conduct business operations. Denial of immediate credit in these cases effectively taxes investment itself.

The problem is compounded by the exclusion of major sectors such as petroleum, electricity, real estate and alcohol from GST coverage. Taxes paid on these cannot be used as credits against GST liabilities and therefore become embedded in downstream costs.

Structurally, thus, India’s GST is an incomplete VAT. When key inputs lie outside its ambit, the credit chain remains patchy and hidden taxes accumulate within production. This ultimately burdens consumers. If India aims to improve the ease of doing business and attract global supply chains, restoring the integrity of the GST credit chain must become central to its tax reform agenda.

The consequences are particularly visible in the export sector. Under the GST framework, exports are intended to be zero-rated so that domestic taxes do not raise export prices. In practice, however, denial of upstream credits and delays in refunds embed unrecoverable taxes into the cost structure of exporters.

When taxes paid on inputs, services or capital goods cannot be fully recovered, exporters must finance these amounts through additional working capital. This raises costs and weakens their price edge in global markets, especially in thin-margin sectors. In an increasingly competitive trade environment, even small cost disadvantages can erode market share.

The distortion is worse in sectors where supplies fall under the 5% rate with restricted ITC. In such cases, ITC on capital goods is either not allowed or significantly curtailed. So GST effectively acts as a tax on production. The tax base, in effect, shifts from consumption to investment. Firms investing in machinery, logistics infrastructure or technology in these sectors cannot fully recover the taxes paid on capital equipment.

The implications are significant.

First, higher investment costs discourage capacity expansion and modernization in export-oriented sectors. Second, domestic producers operating under truncated credit regimes may find themselves at a disadvantage relative to foreign suppliers that benefit from full VAT neutrality. This can encourage greater reliance on imports in certain fields. Third, by raising the cost of capital formation, such restrictions undermine productivity growth and the development of globally competitive manufacturing ecosystems.

In addition, restrictions on credit for capital goods distort relative prices within a production system. Firms facing higher effective tax costs on domestic investment may delay modernization or substitute local products with imported intermediates and finished goods produced under fully creditable VAT regimes abroad. Over time, such asymmetries weaken domestic value addition and reduce the attractiveness of India as a location for globally integrated supply chains.

An inadequate ITC mechanism deters ‘friend shoring’ by international players. Restoring full creditability for business inputs and capital goods is thus essential not only for tax neutrality, but also for the sake of India’s industrial competitiveness.

We have let a tax designed for consumption influence where firms locate plants, how much they invest and whether they participate in global supply chains.

If India aspires to become a global manufacturing hub, GST must function as a genuine VAT. We must eliminate blocked credits unrelated to personal consumption, gradually draw excluded sectors into the GST base and ensure time-bound refunds supported by full digitization. Restoring credit neutrality would reduce costs, improve compliance and strengthen export competitiveness. The next phase of GST reform must therefore focus on ITC.

The author are associated with the Pune International Centre.