GST will help India Inc rethink its business model

Even as hyper competition forces diversified conglomerates to divest unrelated businesses and focus on the core, in India a new force will add to the pressures: the proposed goods and services tax (GST).

In his union budget, finance minister Pranab Mukherjee announced that he intends to shift to GST by next April. That’s just eight months away.

The informed betting is that he will not be able to drive a consensus on GST in the short time available. Both reformers and cassandras have been sending cautionary signals about implementing it prematurely, without adequate preparation.

But even assuming Mukherjee has to delay the GST by another year, companies have to take a close look at their business models today. In particular, they have to figure out how vertically integrated they need to be  or —need not be — in the new regime. 
A brief definitional diversion is useful here.

Conglomeracy, or diversification into non-related businesses, is a form of horizontal expansion for companies or business groups. The logic is often cost savings or synergies in some form, but conglomerate thinking is also driven by the age-old wisdom that you should not put all your eggs in one basket.

For example, if you are an air-conditioning company, you worry about what you will sell after the three summer months. To balance the portfolio, you may buy another business that offers all-weather prospects, or sells better in the monsoons (umbrellas?) or winter (water heaters?).

Very often horizontal expansion is a chase after meaningless growth. It becomes a chimera because the underlying logic is this: ‘My widgets business is slowing down. Infrastructure looks like a sunrise sector. I should build bridges.’ But building widgets and bridges are two different things. A specialist bridge-builder will usually be more competitive than a widget-cum-bridges businessman.

Vertical integration is best explained by the oil industry analogy. The world over, oil companies tend to do everything from oil exploration to refining to petrol retailing to running oil pipelines. It is about capturing all the business opportunities from one end to the other within one company or group. The oil discovered is refined in your factories and piped and shipped to your retail chains — and you collect profit margins all along the way.

In India, vertical integration was driven in the past by a messy tax structure where different commodities had different taxes levied at different rates in different states. Vertical integration was a way to avoid too many taxes at too many stages in the production process.

The shift to value-added tax (VAT, instead of sales tax) has changed the rules of the game. Rates are converging across the country, and central excise is down to a few core rates. The shift to GST will drive rates even closer, with excise, VAT and service taxes getting rolled into two basic taxes, the state and central GSTs.

When this happens, companies that are vertically integrated will have to consider whether they should remain so. Take a company like Reliance, which is vertically integrated from oil prospecting to refining to retailing to petrochemicals to plastics and textiles. When there were so many state and central taxes, it made sense to house all these diverse businesses under one roof. Reason: you pay taxes only twice, once when you buy the raw material, and another when the final product leaves your showroom or factory. There are no taxes in-between.

Once GST kicks in, the implication for business is simple: there will be no difference between taxation at one level of production and another. You can completely break up every stage of production into a separate company and there would be practically no impact on the total taxes you pay.

To give an example: if you are a textile company buying cotton at one end, and then spinning and weaving it, and then transporting it to a showroom for final sale, you can have separate companies (or entities) running each part of the business and the taxes you pay will be the same if you ran all of them under one roof.

Nothing wrong in doing it all under one roof, but what if you are earning higher margins in retailing, and losing it in spinning? You can then focus on the part that you are best at. If you have a very competitive retail business, you can dump your textile factory and source material from the cheapest places. You become more competitive.

Ideally, every company ought to be doing only what it is best at. GST will provide India Inc an opportunity to do just that, undeterred by tax considerations. They need to rethink not only horizontal, but also vertical, integration strategically. Maybe, Reliance should be several companies and not one.