Impact of Recent Tax Reforms on MSMEs In India: Challenges & Growth

Introduction to MSMEs[1]

Micro, small, and medium enterprises (MSMEs) are a vital component of India’s economy, contributing significantly to employment generation, innovation, and overall economic growth. Comprising over 63 million entities, MSMEs account for approximately 30% of India’s GDP and over 45% of total manufacturing output. They play a crucial role in promoting entrepreneurship, reducing regional disparities, and enhancing the country’s export capabilities. However, despite their importance, MSMEs often face numerous challenges, including limited access to finance, inadequate infrastructure, and complex regulatory environments.

In recent years, the Indian government has recognized the need to support and empower MSMEs through various policy initiatives, including significant tax reforms. These reforms aim to streamline tax structures, enhance compliance, and provide incentives that promote growth and formalization within this sector. However, the implementation and effectiveness of these reforms are critical for ensuring that MSMEs can successfully navigate the changing economic landscape.

This chapter will explore the recent tax reforms in India, examining their impact on MSMEs. By analyzing specific provisions, such as reductions in corporate tax rates, the introduction of the Goods and Services Tax (GST), and presumptive taxation schemes, we aim to provide a comprehensive understanding of how these changes have affected the operational landscape for MSMEs. Furthermore, we will highlight the opportunities and challenges these reforms present, offering insights into how MSMEs can adapt and thrive amidst an evolving tax regime.

What are Micro, Small, and Medium enterprises?

Under the provision of Micro, Small & Medium Enterprises Development (MSMED) Act, 2006 the Micro, Small and Medium Enterprises (MSME) are classified as below:

(i) a micro enterprise, where the investment in plant and machinery or equipment does not exceed one crore rupees and turnover does not exceed five crore rupees.

(ii) a small enterprise, where the investment in plant and machinery or equipment does not exceed ten crore rupees and turnover does not exceed fifty crore rupees, and

(iii) A medium enterprise, where the investment in plant and machinery or equipment does not exceed fifty crore rupees and turnover does not exceed two hundred and fifty crore rupees.

What Are Tax Reforms?

Tax reforms refer to significant changes made to a country’s tax system, which may include alterations in tax rates, structures, regulations, and the overall administration of taxation. These reforms are typically designed to achieve various economic, social, and political objectives, such as enhancing tax compliance, increasing revenue, promoting fairness, fostering economic growth, and simplifying the tax system for both individuals and businesses.

Objectives of Tax Reforms

1. Improving Revenue Generation: Governments often initiate tax reforms to enhance their revenue base, allowing for increased funding for public services, infrastructure development, and social programs. By broadening the tax base and optimizing tax rates, governments can collect more taxes without overburdening taxpayers.

2. Promoting Economic Growth: Tax reforms can be used as a tool to stimulate economic growth. By lowering tax rates for businesses or providing incentives for investment in specific sectors, governments aim to encourage entrepreneurship, create jobs, and attract foreign direct investment (FDI).

3. Enhancing Fairness and Equity: Reforms often seek to create a fairer tax system by addressing disparities in tax burdens among different income groups. This may involve adjusting tax brackets, increasing deductions for low-income earners, or introducing progressive tax rates that ensure higher-income individuals pay a larger share of their income in taxes.

4. Simplifying the Tax Code: Complex tax regulations can create confusion and compliance challenges for taxpayers. Tax reforms may involve simplifying tax codes, reducing the number of exemptions and deductions, and streamlining filing processes. This not only helps taxpayers understand their obligations but also reduces administrative burdens on tax authorities.

5. Encouraging Compliance: Effective tax reforms aim to improve compliance rates among taxpayers. By making the tax system more transparent and less burdensome, governments can encourage individuals and businesses to meet their tax obligations willingly, thereby increasing overall tax revenue.

6. Adapting to Economic Changes: Tax reforms are often a response to changing economic conditions, such as shifts in global markets, technological advancements, and evolving social norms. By adapting the tax system to contemporary economic realities, governments can ensure its continued relevance and effectiveness.

Overview of Tax Reforms in India[2]

India’s tax landscape has undergone significant transformations over the past few decades, reflecting the country’s economic evolution and policy objectives. The reform process began in earnest in the early 1990s, aiming to enhance efficiency, broaden the tax base, and simplify compliance for taxpayers. The following sections provide an overview of key milestones in the history of tax reforms in India.

1. Economic Liberalization and Initial Tax Reforms (1991)

The economic liberalization initiated in 1991 marked a turning point for India’s tax system. Faced with a balance of payments crisis, the government embarked on a series of structural reforms, which included reducing high tax rates, simplifying the tax code, and expanding the tax base. The reforms aimed to encourage foreign investment and stimulate economic growth, resulting in a more competitive tax environment. Corporate tax rates were reduced, and exemptions were streamlined, facilitating a more business-friendly ecosystem.

2. Introduction of the Value Added Tax (VAT) (2005)

The introduction of the VAT in 2005 was a landmark reform in India’s indirect taxation framework. VAT replaced the complex cascading system of sales tax with a more transparent and efficient multi-stage tax on goods and services. The reform aimed to reduce tax evasion and enhance compliance among businesses. However, the implementation varied across states, leading to some initial challenges in harmonizing rates and processes.

3. Goods and Services Tax (GST) (2017)[3]

The implementation of the Goods and Services Tax (GST) in July 2017 represented the most comprehensive indirect tax reform in India’s history. GST unified various indirect taxes into a single tax regime, aiming to simplify the tax structure and eliminate the cascading effect of multiple taxes. With GST, businesses are required to comply with a standardized tax framework, enabling greater transparency and efficiency in tax administration. While the reform has significantly benefited larger firms, small and medium enterprises have faced challenges related to compliance, technology adoption, and understanding the complexities of the new system.

4. Corporate Tax Rate Reduction (2019)

In a bid to attract investments and stimulate economic growth, the Indian government announced a reduction in corporate tax rates in September 2019. The new rates, set at 22% for existing domestic companies and 15% for new manufacturing firms, aimed to enhance the profitability of businesses and encourage reinvestment. This reform has been particularly beneficial for MSMEs, providing them with additional resources for expansion and innovation.

5. Presumptive Taxation Schemes

To ease the compliance burden on MSMEs, the Indian government introduced presumptive taxation schemes under Section 44AD of the Income Tax Act. This provision allows eligible MSMEs with an annual turnover of up to ₹2 crore to declare a deemed income of 8% of their turnover (6% for digital transactions), simplifying the tax filing process. This scheme aims to promote formalization and reduce the administrative load on MSMEs, facilitating a smoother tax compliance experience.

6. Ongoing Digitalization and Compliance Initiatives

In recent years, India has increasingly focused on digitalizing its tax administration processes to improve efficiency and transparency. Initiatives such as e-filing of tax returns, electronic invoicing, and the introduction of a unified portal for tax compliance aim to simplify procedures for businesses. These measures are particularly beneficial for MSMEs, which often lack the resources to navigate complex tax systems.

Table 1: Statistical Data on MSMEs in India[4]

Table 2: Schemes Benefiting MSMEs in India (2023-24)[5]

Benefits of Tax Reforms on MSMEs in India

In recent years, India has introduced a series of tax reforms aimed at strengthening the small business ecosystem. These reforms are designed to ease financial burdens, improve access to resources, and encourage growth and innovation among micro, small, and medium enterprises (MSMEs). Some of these reforms have had a particularly positive impact, offering tax incentives, compliance relief, and simplified procedures that make it easier for MSMEs to thrive in a competitive market.

1. Reduction in Corporate Tax Rates[6]

One of the most significant reforms benefiting MSMEs has been the reduction in corporate tax rates. In 2019, the Indian government reduced the corporate tax rate for domestic companies to 22% from the earlier 30%, and for new manufacturing companies, the rate was slashed to an even lower 15% (Section 115BAB, Income Tax Act). MSMEs and start-ups now have access to more working capital, allowing for greater reinvestment in business activities and improved cash flow management. The reduction has also made India’s tax rates more competitive globally, encouraging local businesses to expand and making the country an attractive destination for new investments.

2. Presumptive Taxation Scheme (Section 44AD)

For MSMEs with annual turnovers of up to ₹2 crore, the presumptive taxation scheme under Section 44AD has simplified tax compliance significantly. Instead of maintaining detailed accounts and undergoing audits, eligible businesses are now taxed on a deemed profit basis, allowing them to declare 8% of their turnover as income (6% for digital transactions). This simplification reduces the administrative burden on small business owners, who often lack the resources for detailed tax compliance, and encourages them to maintain digital records, supporting the government’s push towards a cashless economy.

3. Increase in Turnover Limit for GST Registration

The introduction of the Goods and Services Tax (GST) in 2017 was a landmark reform that unified multiple indirect taxes under a single umbrella, benefiting MSMEs by reducing tax cascading. Recognizing the need to simplify compliance further, the government raised the turnover threshold for GST registration from ₹20 lakh to ₹40 lakh in 2019. This change exempted many MSMEs from the requirement to register for GST, allowing them to operate more efficiently and avoid the complexities of tax filings. Additionally, for service providers, the threshold was raised to ₹20 lakh, providing relief to MSMEs in the service sector.

4. MSME Udyam Registration and Priority Sector Lending

To support MSMEs further, the government launched the Udyam Registration in 2020, simplifying the process of identifying and registering MSMEs for easier access to benefits, tax reliefs, and financing options. Registered MSMEs now receive priority sector lending status, making it easier to access loans at lower interest rates. As of 2021, nearly 31 million MSMEs had registered on the Udyam portal, contributing significantly to their financial inclusion and stability. Access to these resources empowers MSMEs to focus on growth rather than survival, positioning them as active participants in India’s economic development.

5. Incentives for Digital Transactions

To promote digital transactions, which offer greater transparency, the government introduced a tax incentive whereby businesses with a turnover of up to ₹5 crore are eligible for a reduced tax rate of 6% on digital payments (as per Section 44AD). This provision not only encourages MSMEs to adopt digital payment systems but also reduces their overall tax liability, helping them retain a larger share of their income for reinvestment and expansion.

6. Tax Holiday and Exemptions for Start-ups

The government has also extended tax incentives specifically aimed at start-ups, many of which fall within the MSME category. Under Section 80-IAC, eligible start-ups are given a tax holiday on profits for any three consecutive years within their first ten years of incorporation. Additionally, angel tax exemptions and the easing of compliance regulations for start-ups have been introduced to make India a more start-up-friendly environment. In FY 2022, over 1,000 start-ups reportedly benefited from these tax holidays, allowing them to focus more on innovation and scaling their businesses rather than on tax liabilities.

Challenges faced by MSMEs due to Tax Reforms in India[7]

While recent tax reforms in India have introduced various benefits for MSMEs, certain provisions have imposed new challenges as well. For many micro, small, and medium enterprises (MSMEs), regulatory burdens, higher costs, and complex compliance requirements have offset some of the positive effects, limiting their ability to scale and compete effectively.

1. Complications Under the Goods and Services Tax (GST)

The implementation of the GST system was aimed at streamlining indirect taxes, but it has introduced compliance challenges, particularly for MSMEs. The mandatory GST compliance requirements, such as monthly and annual filings, frequent changes to filing structures, and complex Input Tax Credit (ITC) rules, have proven cumbersome for MSMEs with limited resources. According to data from the National Small Industries Corporation (NSIC), a significant number of MSMEs struggle with the additional costs of hiring accountants or using software to remain GST-compliant. The compliance burden is amplified by frequent changes in GST rates and structures, which often require MSMEs to adapt quickly, incurring further expenses and operational disruptions.

2. Increase in Audit and Compliance Requirements

The recent expansion in audit requirements, particularly under the Income Tax Act, has affected MSMEs with turnovers exceeding ₹1 crore (or ₹5 crore for digital transactions) that do not opt for presumptive taxation under Section 44AD. This threshold has brought many growing MSMEs into the ambit of mandatory tax audits, leading to higher compliance costs. Audit fees and administrative costs strain businesses with limited financial flexibility, and small business owners often find themselves facing additional scrutiny, paperwork, and regulatory requirements, which take away from time and resources that could be focused on growth.

3. Stringent TDS (Tax Deducted at Source) Regulations

Stringent TDS rules have also impacted MSMEs, which are now required to deduct and remit TDS on a variety of transactions, including payments to contractors, rent, and professional services. The compliance and administrative costs associated with these TDS provisions are disproportionately high for MSMEs, as they often lack dedicated accounting teams. Failure to meet these TDS requirements can lead to penalties, further adding to the financial burden. According to data from the Federation of Indian Micro and Small & Medium Enterprises (FISME), many MSMEs have reported challenges in staying current with TDS obligations, increasing their vulnerability to fines and interest charges on missed payments.

4. Limitations on Input Tax Credit (ITC)

The availability of ITC is a critical feature of the GST system, allowing businesses to offset taxes paid on inputs against their GST liability. However, certain limitations on ITC eligibility have hindered MSMEs. For instance, ITC is denied on goods and services used for personal consumption, and stricter regulations require that ITC claims can only be made if the supplier has filed their returns correctly. MSMEs often deal with suppliers who may not be compliant, which can disallow them from claiming ITC and increase their effective tax burden. Additionally, in cases of GST refunds, MSMEs have faced long delays, affecting their cash flow. According to data from the GST Council, delays in ITC refunds have affected more than 30% of MSMEs, which rely heavily on these funds to maintain working capital.

5. Angel Tax and Valuation Challenges for Start-ups

Although the government has introduced some exemptions for start-ups, the applicability of the so-called “angel tax” under Section 56(2)(viii) remains a challenge for many early-stage companies. This tax applies when start-ups raise funds at a premium to the fair market value of their shares, leading to tax liabilities on the excess amount. Small start-ups and MSMEs have reported difficulties in justifying their valuations to tax authorities, often resulting in tax disputes and unexpected financial burdens. According to a report by the Indian Angel Network, over 400 start-ups were impacted by the angel tax in 2022, creating financial strain and discouraging investment in early-stage ventures.

6. New Compliance and Disclosure Requirements Under Section 206AB

The introduction of Section 206AB mandates higher TDS rates for businesses dealing with vendors who have not filed their income tax returns, further complicating compliance for MSMEs. Under this rule, MSMEs are required to check the tax filing status of each vendor, placing additional administrative burdens on already stretched teams. Non-compliance with this provision can lead to penalties and higher tax costs, affecting cash flow and imposing further financial strain on MSMEs that rely on multiple vendors. According to the Central Board of Direct Taxes (CBDT), around 60% of MSMEs report difficulties in verifying vendor compliance, leading to increased TDS expenses.

Case Studies and Examples

Case Study 1: Tech Start-Up – Zomato[8]

Background: Zomato, an Indian multinational restaurant aggregator and food delivery company started as a small start-up in 2008. With a vision to transform the food service industry, Zomato faced various challenges during its early years, particularly in navigating the tax landscape.

Impact of Tax Reforms: The introduction of the Goods and Services Tax (GST) significantly benefited Zomato as it streamlined the taxation process for online food delivery services. Under the GST regime, Zomato could claim Input Tax Credits (ITC) on the goods and services it procured, which reduced its operational costs. Moreover, the simplification of indirect taxes allowed Zomato to expand rapidly without being burdened by the complexities of varying state tax structures. The reduction in corporate tax rates announced in 2019 further facilitated Zomato’s growth, enabling the company to reinvest profits into innovation and technology development.

Outcome: Zomato went public in 2021, achieving a market valuation of over $13 billion. The streamlined tax environment contributed to its growth trajectory, demonstrating how tax reforms can empower tech start-ups to thrive.

Case Study 2: Manufacturing MSME – Bansal Steel[9]

Background: Bansal Steel is a medium-sized steel manufacturing company based in Maharashtra. It has been operational for over 15 years and primarily serves the local construction industry.

Impact of Tax Reforms: The presumptive taxation scheme under Section 44AD has significantly reduced the compliance burden for Bansal Steel. By allowing the company to declare 8% of its turnover as income, the scheme simplified tax filing and reduced the need for extensive record-keeping. Furthermore, the introduction of GST allowed Bansal Steel to consolidate its tax payments into a single transaction, which improved cash flow management.

Outcome: As a result of these tax reforms, Bansal Steel reported a 25% increase in profit margins in the last fiscal year, enabling it to invest in new machinery and expand production capacity. The streamlined tax compliance processes have allowed Bansal Steel to focus more on core business operations rather than on navigating complex tax regulations.

Case Study 3: E-commerce MSME – Chumbak[10]

Background: Chumbak is an Indian e-commerce company specializing in home decor and lifestyle products. It started as a small venture but grew rapidly due to the increasing demand for unique Indian designs.

Impact of Tax Reforms: The implementation of GST had a mixed impact on Chumbak. While the unified tax structure simplified operations by replacing multiple state taxes, the initial adjustment phase posed challenges in terms of compliance and technology requirements. However, the reduction in corporate tax rates provided Chumbak with a significant boost in profitability, enabling it to invest in marketing and product development.

Outcome: Chumbak’s revenue doubled within two years post-GST implementation, reflecting the benefits of a consolidated tax system. The company has since expanded its product range and opened physical stores, demonstrating the positive long-term effects of tax reforms on its growth.

Case Study 4: Agriculture-Based MSME – AgroTech Foods[11]

Background: AgroTech Foods is a small enterprise focused on processing and exporting organic agricultural products. Operating in a sector highly influenced by taxation, the company faced challenges in maintaining profitability due to varying state taxes.

Impact of Tax Reforms: The introduction of GST helped AgroTech Foods eliminate the cascading effect of taxes on its raw materials and exports. The ability to claim ITC on inputs reduced overall production costs. Additionally, the government’s support for organic farming and MSME sectors through various subsidy schemes complemented the tax reforms, allowing AgroTech Foods to enhance its product offerings.

Outcome: After the implementation of GST, AgroTech Foods reported a 30% increase in exports. The improved tax framework enabled the company to enhance its competitiveness in the global market, highlighting the positive impact of tax reforms on agriculture-based MSMEs.

Policy Recommendations

To further strengthen the positive impact of tax reforms on micro, small, and medium enterprises (MSMEs) in India, the following policy recommendations can be considered:

1. Enhance Simplification of Tax Compliance

• Streamlined Processes: The government should continue to simplify tax compliance procedures for MSMEs by reducing the number of required filings and documentation. Implementing user-friendly online platforms can help MSMEs navigate tax obligations more efficiently.
• Awareness Campaigns: Conduct regular awareness campaigns to educate MSMEs about tax compliance, available exemptions, and the benefits of new tax policies. Providing clear guidance and support will help entrepreneurs better understand and utilize the tax system.

2. Strengthen Presumptive Taxation Schemes

• Expansion of Eligibility Criteria: Broaden the eligibility criteria for presumptive taxation schemes to include a larger segment of MSMEs. Increasing the turnover threshold and allowing more sectors to qualify can enhance participation and compliance.
• Regular Review and Adjustment: Implement regular reviews of presumptive taxation rates to ensure they remain relevant and beneficial for MSMEs. Adjusting these rates in line with inflation and market conditions can provide necessary relief.

3. Encourage Digital Adoption

• Incentives for Digitalization: Provide financial incentives or grants for MSMEs to adopt digital accounting and compliance tools. These tools can streamline tax processes and reduce the likelihood of errors in filing.
• Capacity Building Programs: Establish training programs to enhance the digital skills of MSME owners and employees, focusing on e-filing, record-keeping, and utilizing technology for compliance.

4. Strengthen Access to Finance

• Tax Incentives for Investment: Introduce tax deductions or credits for MSMEs that invest in technology, equipment, or infrastructure improvements. This can encourage reinvestment and growth within the sector.
• Simplified Loan Schemes: Develop simplified loan schemes specifically tailored for MSMEs, linking favorable terms to tax compliance. Banks can be incentivized to offer lower interest rates for businesses with a good tax compliance record.

5. Facilitate Sector-Specific Support

• Targeted Incentives for Key Sectors: Provide tailored tax incentives for MSMEs operating in key sectors, such as technology, agriculture, and manufacturing, to stimulate growth in areas critical to the economy.
• Support for Women and Minority Entrepreneurs: Create specific tax incentives and grants for MSMEs led by women and minorities, fostering diversity and inclusivity within the business ecosystem.

6. Regular Monitoring and Feedback Mechanisms

• Establish Feedback Channels: Create formal channels for MSMEs to provide feedback on tax policies and reforms. Engaging with business owners can help policymakers identify pain points and areas for improvement.
• Periodic Reviews of Tax Policies: Conduct regular reviews of tax policies to assess their effectiveness and make necessary adjustments. Monitoring the impact of reforms on MSMEs can ensure that policies remain relevant and beneficial.

Conclusion

The landscape of micro, small, and medium enterprises (MSMEs) in India is dynamic and multifaceted, serving as a cornerstone for economic growth, employment generation, and innovation. Recent tax reforms, particularly the introduction of the Goods and Services Tax (GST), presumptive taxation schemes, and reductions in corporate tax rates, have significantly altered the operational environment for MSMEs. While these reforms have opened up new avenues for growth and provided much-needed relief, they have also presented challenges that require careful navigation.

This chapter has explored both the positive and negative impacts of these reforms on MSMEs, highlighting how changes in the tax landscape can empower MSMEs to expand and innovate while also imposing new compliance burdens. The case studies examined demonstrate the diverse experiences of MSMEs across sectors, emphasizing that while many have thrived, others continue to struggle with the complexities of tax compliance and the rapid pace of regulatory changes.

To maximize the benefits of tax reforms for MSMEs, policymakers must prioritize the simplification of tax processes, enhance digital adoption, and create sector-specific support systems. The recommendations provided in this chapter aim to foster a more enabling environment for MSMEs, ensuring they can effectively contribute to India’s economic growth.

As the Indian economy continues to evolve, the ongoing dialogue between the government and MSME stakeholders will be crucial in shaping future tax policies. By listening to the voices of small business owners and adapting tax reforms to meet their needs, India can create a robust ecosystem that not only supports MSMEs but also drives sustainable development and innovation in the years to come.

In conclusion, the impact of recent tax reforms on MSMEs in India is a testament to the vital role that effective tax policy plays in nurturing entrepreneurship. As the nation strives for inclusive growth, empowering MSMEs through thoughtful and responsive tax reforms will be key to unlocking their full potential and ensuring a resilient economic future.

[1] Introduction of MSMEs available at Ministry of Micro, Small and Medium Enterprises, Government of India. “Annual Report 2020-21.” https://www.msme.gov.in/sites/default/files/FINALMSMEANNUALREPORT2023-24ENGLISH.pdf  ( last visited on 30^th October, 2024).

[2] “Objectives of Tax Reforms in India.” Available at  https://www.unescap.org/sites/default/files/apdj-7-2-3-rao.pdf   (Last visited on  30^th October, 2024).

[3] GST Implementation Effect available at KPMG. (2020). “GST Impact on Indian MSMEs. ” https://kpmg.com/in/en/home/services/tax/indirect-tax/goods-and-services-tax.html (Last visited on 30^th October, 2024).

[4] Statistical Data on MSMEs in India available at Ministry of Micro, Small and Medium Enterprises, Government of India. “Annual Report 2023-24.” https://www.msme.gov.in/sites/default/files/FINALMSMEANNUALREPORT2023-24ENGLISH.pdf (last visited on 30^th October, 2024).

[5] Schemes Benefiting MSMEs in India available at the Ministry of Micro, Small and Medium Enterprises, Government of India. “Annual Report 2023-24.” https://www.msme.gov.in/sites/default/files/FINALMSMEANNUALREPORT2023-24ENGLISH.pdf (last visited on 30^th October, 2024)

[6] Corporate Tax Rate Reduction: An Overview.” Available at  https://cleartax.in/s/corporate-tax (Last visited  on 30^th October, 2024).

[7] Challenges in GST Compliance for MSMEs available at https://www.epw.in/journal/2020/18/special-articles/small-businesses-big-reform.html (last visited on 30th October, 2024)

[8] A case study of zomato available athttps://www.researchgate.net/publication/341010072_A_case_study_on_Zomato_-_The_online_Foodking_of_India  (last visited on 30th October, 2024)

[9] Bansal Wire Industry Pvt Ltd available at https://www.screener.in/company/BANSALWIRE/ Last visited on 30^th October, 2024

[10] A case study on Chumbak available at https://economictimes.indiatimes.com/tech/startups/goat-brand-labs-acquires-chumbak-four-others-as-consolidation-sets-in-d2c-sector/articleshow/96933003.cms?from=mdr Last visited on 30^th October, 2024

[11] A case study on AgroTech Foods Pvt Ltd  available at https://www.goodreturns.in/company/agro-tech-foods/accounting-policy.html   last visited on 30^th October, 2024