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Inflation, the sustained increase in the general price level of goods and services in an economy, has been a persistent challenge for India. It affects every stratum of society, eroding purchasing power and influencing economic decisions. While multiple factors contribute to inflation, the cascading impact of direct and indirect taxation remains a crucial yet underexplored aspect of the problem. This blog delves into how the intricate structure of India’s taxation system exacerbates inflationary pressures, impacting both consumers and businesses.

Understanding Inflation in India

Inflation in India is measured primarily through the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). While the CPI reflects the retail prices of goods and services, the WPI tracks the price movement at the wholesale level. Both indices have shown volatility over the years, influenced by factors such as supply chain disruptions, global oil prices, and domestic economic policies.

However, a significant yet often overlooked contributor to inflation is the structure and implementation of both direct and indirect taxes. Let’s dissect how these taxes cascade through the economy and add to inflationary pressures.

The Cascading Impact of Indirect Taxes

Indirect taxes, such as the Goods and Services Tax (GST), excise duty, and customs duty, are taxes on consumption. These taxes are levied at various stages of the supply chain, from production to final sale. While GST was introduced with the intention of eliminating the cascading effect of multiple indirect taxes, in practice, it has not entirely succeeded in curbing inflationary pressures.

1. Input Tax Credit (ITC) Limitations: The GST framework allows for input tax credit, which theoretically reduces the tax burden on businesses. However, there are several restrictions and conditions under which ITC can be claimed. These limitations often result in businesses not being able to fully offset their tax liabilities, leading to an increase in the cost of goods and services, which is eventually passed on to consumers.


2. High GST Slabs: Essential commodities like food, healthcare, and education services are either exempt or taxed at lower rates. However, several items still fall under higher GST slabs (18% and 28%), which increases their cost directly. This, coupled with the compounding effect of taxes at different stages of production and distribution, leads to a higher retail price, contributing to inflation.


3. Excise Duty on Fuel: The government’s reliance on excise duty on fuel as a significant revenue source has a direct impact on inflation. Since fuel is a critical input for various industries and the transportation sector, any increase in fuel prices due to higher excise duties translates to increased costs across the board. This has a ripple effect on the prices of essential goods and services, exacerbating inflation.


4. Customs Duty and Import Tariffs: Protectionist policies aimed at supporting domestic industries often involve high import tariffs and customs duties. While these measures protect local industries, they also increase the cost of imported goods and raw materials. For a country like India, which relies heavily on imports for several essential commodities, this contributes significantly to inflation.



The Role of Direct Taxes

While indirect taxes are more visible in their inflationary impact, direct taxes like income tax and corporate tax also play a role, albeit indirectly.

1. Corporate Tax and Cost-Push Inflation: Higher corporate tax rates can lead to increased operational costs for businesses. Companies may choose to pass on this burden to consumers in the form of higher prices, contributing to cost-push inflation. Although recent reforms have aimed at reducing corporate tax rates, the benefits of these reductions have not fully percolated to the end consumers.


2. Income Tax and Disposable Income: High personal income tax rates reduce disposable income for consumers, which can lower demand for non-essential goods and services. While this might seem deflationary, reduced consumption can lead to lower production, reduced economies of scale, and ultimately higher costs per unit of production. This paradoxical effect can contribute to inflation, particularly in the services sector.



Taxation and the Informal Economy

India’s large informal economy presents unique challenges. The compliance burden of indirect taxes like GST has pushed many small businesses to either increase prices or operate outside the formal tax net. This not only distorts competition but also leads to higher prices for consumers who purchase from the formal sector, thereby contributing to inflation.

The Policy Conundrum

Addressing inflation through taxation reforms is a complex policy conundrum. On one hand, reducing taxes can stimulate consumption and lower prices, but it also reduces government revenue, which is crucial for funding public welfare programs. On the other hand, maintaining high taxes can lead to inflation and reduced purchasing power.

The government has attempted to strike a balance through measures such as rationalizing GST rates, reducing corporate tax rates, and providing income tax reliefs. However, these measures have not been sufficient to tackle the broader issue of inflation. Structural reforms aimed at simplifying the tax regime, reducing compliance burdens, and ensuring more efficient tax administration are needed to address the root causes of inflation.



The cascading impact of direct and indirect taxation in India contributes significantly to inflationary pressures. While the government has made strides in tax reforms, the complex interplay of these taxes continues to affect the economy adversely. A more holistic approach, focusing on simplifying the tax structure and ensuring equitable tax distribution, is essential for mitigating inflation and ensuring sustainable economic growth.

For policymakers, the challenge lies in finding a middle ground where taxation does not become a burden on the economy but serves as a tool for inclusive growth. As India continues its journey towards becoming a $5 trillion economy, addressing the inflationary impact of its taxation system will be crucial for ensuring economic stability and prosperity.