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Home / Opinion / Views /  Why higher GST on chit funds is a bad idea

Despite 75 years of independence, access to borrowings from commercial banks, especially for meeting emergency needs, remains elusive for the majority of Indian households. Many Indians work in the informal sector or are self-employed. They 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. This forces them to rely on sources of credit such as non-banking financial companies (NBFCs), friends and relatives, and local money lenders and pawnbrokers.

One such long-established alternative source of credit is chit funds, which are one of the earliest forms of peer-to-peer lending. Chit funds, if registered with a state government, are legal entities regulated under the Chit Funds Act of 1982; they do not fall under the jurisdiction of the Reserve Bank of India. In the government’s recent announcement of revised rates of GST, the tax that chit fund services attract has been raised to 18% from the earlier 12%.

How will this tax hike impact the chit fund industry and thus people for whom it is a key financial instrument?

To begin with, let us understand how the product works. A chit fund is a close-ended group lending scheme with rounds of funding, where cyclical iterations equal the number of participants. The cycle ends after each fund participant has received the pool of money once. At a preset interval, typically every month, a lump-sum from the contribution of all participants is transferred to one of them who wins that month’s bid for the pool of money. A piece of paper used for writing a bid amount in the olden days was known as a chit, and hence the name ‘chit fund’.

A chit fund is a unique hybrid instrument that allows an individual to switch from being a borrower to a saver/lender in a seamless fashion. One can borrow against traditional banking/insurance instruments such as fixed deposits, insurance policies, provident fund, etc, but that requires them to undergo a cumbersome credit-approval process and the loan is restricted to a fraction of past contributions already made to the collateral 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 devolves to the chit fund’s promoter.

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. Each participant, therefore, receives a different pool of funds. Bids tend to be more aggressive early in the cycle and so people who take the lump-sum early end up paying more by way of their total contribution over the duration of the fund than what they receive from it. Those who take it towards the end of the cycle tend to end up as savers, since they usually receive more money than what they contribute to the chit fund.

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Since the cost of borrowing and the return to savers depend on the bidding process, it is uncertain, varies for each participant, and can be calculated only ex-post. Every month, each participant makes an identical contribution to the lump-sum, though the contribution differs each month. It is calculated as the winning bid plus the commission of the chit fund intermediary, which is currently around 5% of the full lump-sum amount, 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% in interest cost, lower than most other sources of credit, especially after accounting for guaranteed access to loans without collateral. For those who end up as savers, the interest earned is a maximum of 4-6% or often even lower. Our estimates also suggest that in response to the hike in GST, if chit fund intermediaries were to raise their monthly commission to 7% (the most allowed by law) from the current 5%, then the cost of borrowings is likely to increase by around 0.85% with a similar decline in the already-low returns that chit-fund savers make.

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 on account of the GST hike, especially in an environment of rising interest rates. If participants who joined chit funds with an intention of being savers were to switch over to alternative saving instruments, then the chit fund system would not work, since it requires a group of people that must comprise a mix of expected savers and borrowers. If the chit fund industry shrinks, then borrowers would have to find a substitute source of unsecured financing, which will not be an easy task.

It is difficult to evaluate the net income of chit fund promoters in the absence of data on their costs, default rates of participants and the net tax burden. Overall, however, professional chit funds have served a segment of the Indian population well for whom it is not easy to get loans, especially rollover loans from banks, NBFCs and even microfinance institutions.

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

Vidya Mahambare & Sanjoy Sircar are, respectively, professor of economics and professor of finance at Great Lakes Institute of Management, Chennai. 

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