Hike funding

Why GST on receipts is a bad idea

Despite 75 years of independence, access to borrowing from commercial banks, especially to meet emergency needs, remains elusive for the majority of Indian households. Many Indians work in the informal sector or are self-employed. They don’t have steady streams of income, proof of regular income, or collateral that banks need to sanction personal loans and small business loans. This forces them to rely on sources of credit such as non-bank financial companies (NBFCs), friends and relatives, and local moneylenders and moneylenders.

One such long-established alternative source of credit is chit funds, which is one of the earliest forms of peer-to-peer lending. Bond funds, if registered with a state government, are legal entities governed by the Bond Funds Act of 1982; they are outside the jurisdiction of the Reserve Bank of India. In the government’s recent announcement of revised GST rates, the tax that voucher fund services attract has been increased to 18% from the previous 12%.

What impact will this tax hike have on the chit fund industry and therefore on the people for whom it is a key financial instrument?

To begin, let us understand how the product works. A chit fund is a closed group lending system with funding cycles, where the cycle iterations equal the number of participants. The cycle ends once each participant in the fund has received the pool of money once. At a predefined interval, usually every month, a lump sum from the contribution of all participants is transferred to one of them who wins the auction of the month for the pool of money. A piece of paper used to write down a bid amount in ancient times was known as a voucher, hence the name “voucher background”.

A chit fund is a unique hybrid instrument that allows an individual to seamlessly transition from borrower to saver/lender. One can borrow against traditional banking/insurance instruments such as fixed deposits, insurance policies, provident funds, etc., but this requires them to go through a cumbersome credit approval process and the loan is limited to a fraction of past contributions already made to the guarantee. Kitty. In the case of a chit fund, any investor can bid to borrow from others against the promise of future contributions, while the credit risk is vested in the sponsor of the chit fund.

One can bid early in the cycle if one needs money for a planned purchase, working capital for a business, or a personal emergency. Alternatively, one can wait and take the lump sum in a later part of the cycle. Each participant therefore receives a different pool of funds. Offers tend to be more aggressive early in the cycle, and as a result people who accept the lump sum early end up paying more through their total contribution over the life of the fund than they receive. Those who take it towards the end of the cycle tend to become savers, since they usually receive more money than they contribute to the chit fund.

Since the cost of borrowing and the return to savers depends on the bidding process, it is uncertain, varies for each participant, and can only be calculated ex-post. Each month, each participant pays an identical contribution to the package, but the contribution differs each month. It is calculated as the winning bid plus the chit fund broker’s commission, which is currently around 5% of the total lump sum, divided by the number of participants.

Our calculations based on data from a few completed chit fund cycles suggest that borrowers in chit funds pay around 10-18% interest charges, which is lower than most other sources of credit, especially after having taken into account guaranteed access to unsecured loans. For those who end up becoming savers, the interest earned is a maximum of 4-6% or often even lower. Our estimates also suggest that in response to the GST hike, if chit fund intermediaries were to increase their monthly fee to 7% (the highest permitted by law) from the current 5%, the cost of borrowing would likely increase. by around 0.85% with a similar drop in the already low yields of savers on cash certificates.

While borrowers would still be happy to participate in chit funds, given that their interest rates remain attractive, the opportunity cost of participation increases for savers due to higher GST, especially in a rising interest rate environment. If participants who joined chit funds with the intention of being savers were to switch to alternative savings instruments, then the chit fund system would not work, as it requires a group of people who must comprise a mix expected savers and borrowers. If the chit fund industry shrinks, borrowers will have to find an alternative unsecured source of funding, which will not be an easy task.

It is difficult to assess the net income of chit fund promoters in the absence of data on their costs, participant default rates and net tax burden. On the whole, however, funds from good professionals have served a segment of the Indian population well for whom it is not easy to obtain loans, especially revolving loans from banks, NBFCs and even from microfinance institutions.

Careful reconsideration of the recent 18% GST hike on chit fund services is therefore warranted.

Vidya Mahambare and Sanjoy Sircar are Professor of Economics and Professor of Finance respectively at Great Lakes Institute of Management, Chennai

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