The increasing formalisation of the Indian economy, especially through digitisation, is an inexorable advance that will upend the business model — based on the twin arbitrage of labour and cash transactions — of micro, small and medium enterprises (MSMEs).

India’s paradigm shift to the Goods and Services Tax (GST) regime in July will increase their compliance costs and snare a majority of them into the indirect tax net for the first time.

Sharp practices

So far, unorganised MSMEs have grown faster than organised peers because of lower cost structures stemming from tax avoidance, and not having to pay social security benefits to employees (such as provident fund and gratuity), and excise duty (if turnover is less than ₹1.5 crore).

Some MSMEs also understate employee base or set up multiple ventures to avoid breaching tax thresholds. Such sharp practices helped them price products and services competitively over the past few decades and also maintain operating margins at organised player levels.

The vicissitudes resulting from the impact of GST are many. To wit, for manufacturers, the reduction in the threshold for GST exemption to ₹20 lakh from ₹1.5 crore means tens of thousands of unorganised MSMEs will soon be cast into the tax net.

And digital transaction trails created by dual authentication of invoices under GST will strengthen tax compliance. Additionally, a lower tax burden under GST will reduce the cost of raw materials and logistics.

For example, a study by Crisil shows that freight costs could decline 1.5-2 per cent once GST kicks in.

Different for services

For the services sector, though, the tax burden will increase. Hence, organised players with the ability to hold their price-lines, or pass on any increase in cost to customers, will be able to maintain or improve profit margins.

We believe a simplified tax structure and a unified market will improve operational efficiencies, especially of MSMEs with a wider reach.

Then again, there was demonetisation. Last fiscal, MSMEs were expected to record on-year topline growth of 14 to 16 per cent.

However, the impact of demonetisation has been severe in the second half and they would have closed the year with an increase of just 6 to 8 per cent.

But as the effects of demonetisation fade, growth will pick up in the current fiscal.

Given all this, what are Crisil SME Ratings’ outlook on key sectors after GST is promulgated?

A peep into outlook

Positive for light engineering : Light engineering MSMEs rated by Crisil saw 15 per cent compound annual growth rate in topline between fiscals 2014 and 2016, with demonetisation causing just a blip.

GST is expected to provide a boost to this segment because of lower tax incidence.

The Government’s thrust on ‘Make in India’ will also lead to continued investments, helping the sector maintain growth momentum.

Positive for electrical equipment : Sales in companies rated by Crisil grew way faster at about 23 per cent in fiscal 2016 compared with 16 per cent in 2015. The sector will benefit from lower freight costs and tax rates.

Though growth is expected to be strong this fiscal, cheaper imports, especially from China, remain a challenge.

Neutral for pharmaceuticals : Sales in companies rated by Crisil grew 11 per cent in fiscal 2016 compared with 15 per cent in 2015.

Demonetisation had a limited impact as the Government had allowed extended use of the banned ₹500 and ₹1,000 currency notes for purchasing medicines.

We do not foresee any significant difference in tax rates under GST. This fiscal, too, we expect similar growth.

Neutral for auto components : Between fiscals 2014 and 2016, sales by unorganised auto component makers rated by Crisil grew at 14 per cent annually compared with 7 per cent for their organised peers.

However, demonetisation led to a short-term drop in sales to original equipment manufacturers (OEMs), or vehicle makers.

This fiscal, OEM sales are expected to normalise. Organised players will benefit and record moderate growth given the thrust on digitisation and lower tax rates under GST.

Unorganised players catering mostly to the non-OEM replacement market will be forced to move into the organised domain.

Marginally negative for textiles : Sales growth in the textiles-related MSME segment had already declined from 15 per cent in fiscal 2015 to 8 per cent in 2016.

GST will have a marginally negative impact because of higher tax rates expected.

During Crisil’s interactions with clients, some of them raised concerns that a unified market would create more competition in an already crowded and price-sensitive arena with a large number of unorganised players.

Organised players dealing in branded apparel are expected to fare well, though.

The sector is expected to record below-par growth of 5 per cent or lower.

Marginally negative for leather and footwear sectors : Companies Crisil rates in this segment have seen muted growth and have borne the brunt of demonetisation. With competition, including from Chinese players being strong, the operating margin has fallen to as low as 6 per cent for organised players.

We do not expect GST rates to vary much from the current indirect tax rates. Crisil expects overall growth and margins of players to remain subdued this fiscal.

The writer is the business head of CRISIL Ratings-SME