Why higher GST on chit funds is a bad idea

Source: The post is based on an article “Why higher GST on chit funds is a bad idea” published in the Live Mint on 11^th August 2022.

Syllabus: GS 2 Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development, and Employment.

News: Recently, the Government of India has made an announcement of revised rates of GST on the chit funds. The tax has been raised from the earlier 12% to 18%.

About Chit Fund

It is an alternative source of credit, which is the earliest form of peer-to-peer lending.

In this, a piece of paper is used for writing a bid amount, known as a chit. Therefore, it is known as a ‘chit fund’.

It doesn’t fall under the jurisdiction of the Reserve Bank of India. These are the legal entities, registered with and regulated by, the state governments under the Chit Funds Act of 1982.

Functioning of the Chit Funds

A chit fund is a close-ended group lending scheme. In this, funding is involved in a cycle. The cycles end after each fund participant has received the pool of money once.

For Example, every month, each participant makes an identical contribution to the lump sum. And a lump-sum amount collected from the contribution of all participants is transferred to one of them who wins that month’s bid for the pool of money. The cost of borrowing and the return to savers depend on the bidding process.

The chit fund intermediary currently charges around 5% of the full lump-sum amount, divided by the number of participants.

What are the benefits of the Chit Fund system?

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 devolves to the chit fund’s promoter.

A chit fund is a unique hybrid instrument that makes an individual a saver/lender instead of a borrower.

One can bid early in the cycle if one needs money for any planned purchase, working capital for business, or for a personal emergency. Alternatively, one can wait and take the lump sum in a later part of the cycle.

Professional chit funds have served a segment of the Indian population that do not have stable income streams, proof of regular income, or the collateral that banks need to sanction personal as well as small business loans.

Borrowers in chit funds pay interest lower than most other sources of credit.

For savers, the interest earned is a maximum of 4-6% or often even lower.

How will the GST hike impact the chit fund industry? 

The chit fund intermediaries can raise their monthly commission from the current 5% to 7% (the most allowed by law). This will increase the cost of borrowings in the fund. Similarly, there would also be a decline in the already-low returns that chit-fund savers make.

The savers may switch to alternative saving instruments in an environment of rising interest rates. Therefore, it would make borrowing difficult as there would be inadequate savings.

If the chit fund industry shrinks, then borrowers would have to find a substitute source of unsecured financing.