GST Reforms and the Formalisation of MSMEs in India: Sectoral Opportunities and Compliance Challenges

Abstract The introduction of the Goods and Services Tax (GST) in July 2017 marked a landmark reform in India’s indirect taxation system. By subsuming multiple indirect taxes into a unified tax structure, GST aimed to simplify taxation, remove cascading effects, and promote a unified national market. One of the key policy expectations of GST was the formalisation of businesses, particularly Micro, Small and Medium Enterprises (MSMEs), which constitute the backbone of the Indian economy. However, a substantial proportion of MSMEs historically operated in the informal sector, limiting their access to formal credit, institutional support, and wider markets. GST reforms introduced mechanisms such as input tax credit, e-way bills, digital invoicing, and nationwide tax compliance systems that incentivised enterprises to register under the tax framework. While GST has accelerated the formalisation of many MSMEs and improved supply chain transparency, it has also introduced compliance challenges, technological barriers, and financial constraints for smaller enterprises. This study examines the role of GST reforms in promoting the formalisation of MSMEs in India while analysing sectoral opportunities and compliance challenges. The research adopts a descriptive and analytical approach using secondary data from government reports, policy documents, and academic literature. The findings suggest that GST has significantly contributed to business formalisation and market integration but requires further policy refinements to reduce compliance burdens and enhance the ease of doing business for MSMEs. The study concludes with policy recommendations aimed at strengthening GST implementation to support inclusive economic growth and sustainable development of the MSME sector. Keywords: GST, MSMEs, Formalisation, Tax Reforms, Informal Economy, Economic Growth, Compliance Challenges 1. Introduction India’s indirect tax system prior to 2017 was characterised by a complex structure involving multiple taxes imposed by both the central and state governments. Businesses were required to comply with a variety of taxes which created several economic inefficiencies. One of the most significant problems was the cascading effect of taxes, where taxes were levied on already taxed goods and services. In addition, different tax rates across states created barriers to interstate trade, increased compliance costs, and reduced overall economic efficiency. Recognising these structural challenges, the Government of India introduced the Goods and Services Tax (GST) on July 1, 2017 as a comprehensive indirect tax reform replacing multiple indirect taxes with a unified tax framework. The reform aimed to simplify taxation, remove cascading effects, create a common national market, and improve tax compliance. Among the key objectives of GST was the expansion of the formal economy by encouraging businesses to register under the tax system. Formalisation refers to the process through which economic activities move from the informal sector into the regulated and documented framework of the formal economy. The Micro, Small and Medium Enterprises (MSME) sector represents a critical component of the Indian economy and plays a vital role in promoting inclusive growth and employment generation and also contribute significantly to industrial output, exports, innovation, and regional development. Despite their significant contribution to the economy, a large proportion of MSMEs historically operated in the informal sector. The absence of formal registration and proper financial documentation restricted their ability to access bank credit and participate in organised supply chains. The introduction of GST was expected to address several of these issues by incentivising businesses to formalise their operations and create several new opportunities for MSMEs and also to reap the advantages of being in the formal sector. However, despite these potential benefits, the transition to the GST regime has not been without challenges. Many MSMEs have faced difficulties in adapting to the new tax system due to compliance complexities, technological barriers, and financial constraints. Against this background, the present study examines the role of GST reforms in promoting the formalisation of MSMEs in India while analysing the sectoral opportunities and compliance challenges emerging from the new tax regime. The study seeks to contribute to the growing body of literature on tax reforms and economic formalisation by providing a comprehensive analysis of the relationship between GST and MSME development in India. 2.Review of Literature Several studies have examined the implications of GST for economic growth, business efficiency, and the functioning of MSMEs. Early discussions on GST in India focused on its potential to simplify the indirect tax system and eliminate cascading taxation. Kelkar (2018) highlighted that GST strengthens fiscal federalism by creating a coordinated tax framework between the central and state governments. The report emphasised that GST would enhance tax compliance and expand the tax base by integrating informal economic activities into the formal tax system. Sharma and Singh (2019) analysed the implications of GST for small businesses and concluded that the reform encourages formalisation through mechanisms such as input tax credit and digital compliance systems. However, the study also noted that many MSMEs initially struggled with compliance due to limited financial and technological resources. Mukherjee (2018) examined the macroeconomic implications of GST implementation and found that the reform improves supply chain efficiency and reduces logistics costs. The study highlighted that the elimination of interstate tax barriers enables firms to restructure their supply chains and expand their market reach. Rao (2019) focused on the relationship between GST and tax compliance in India. According to the study, GST encourages businesses to formalise their operations because firms can claim input tax credits only when both buyers and sellers are registered within the GST network. This mechanism creates incentives for enterprises to operate within the formal tax system. Garg (2019) examined the impact of GST on the manufacturing sector. The study found that GST improved production efficiency by reducing tax-related distortions and encouraging integrated supply chains across states. Manufacturing MSMEs particularly benefited from simplified tax procedures and improved logistics efficiency. Kumar and Gupta (2020) analysed compliance challenges faced by MSMEs under GST. The study revealed that small enterprises faced difficulties due to frequent return filing requirements and digital compliance procedures. Many small businesses lacked adequate technological infrastructure and accounting expertise to manage GST compliance effectively. Deloitte (2018) reported that GST has significantly improved transparency in taxation by introducing digital tax filing systems and automated compliance mechanisms. The report suggested that GST has contributed to the formalisation of business activities by integrating firms into the digital tax ecosystem. NITI Aayog (2021) highlighted the role of GST in promoting digitalisation within the Indian economy. The report observed that GST compliance systems encourage businesses to maintain digital records, which improves transparency and accountability in economic transactions. World Bank (2019) also recognised GST as a key reform improving India’s business environment. The report argued that GST contributes to ease of doing business by simplifying tax procedures and reducing regulatory complexity. The present study builds upon existing research by examining the dual impact of GST reforms on MSME formalisation in India, focusing on both sectoral opportunities and compliance challenges. 3.Objectives of the Study The specific objectives of the study are as follows: To examine the role of GST reforms in promoting the formalisation of MSMEs in India. To analyse the sectoral opportunities created by GST for MSMEs. To identify the major compliance challenges faced by MSMEs under the GST regime. To suggest policy recommendations for improving GST implementation for the MSME sector. 4.Research Methodology The present study adopts a descriptive and analytical research methodology to examine the relationship between GST reforms and the formalisation of MSMEs in India. The analysis is based on secondary data collected from various sources, including Ministry of MSME reports, Economic Survey of India, GST Council publications, NITI Aayog reports, World Bank reports, Academic journals and research papers, Industry reports from consulting organisations. 5. MSME Formalisation after GST Prior to GST, a large proportion of MSMEs operated in the informal sector, remaining outside the tax system due to complex tax regulations, multiple state taxes, and limited incentives to register. The changes introduced under GST have encouraged many small enterprises to enter the formal economy. The GST regime has played a crucial role in accelerating this transition. 5.1Increase in GST registrations Significant increase in the number of registered MSME taxpayers is an evident formalisation after GST. GST registration has become a prerequisite for businesses wishing to participate in organised supply chains, claim input tax credits, and access various government benefits. The number of GST tax payers’ registrations of MSMEs has notably increased from 65 lakhs in 2017 to 1 crore in 2019, 1.3 crores in 2022, 1.4 crores in 2024 and around 1.53 crores in 2025. 5.2 Role of Input Tax Credit in Formalisation One of the most significant mechanisms encouraging MSME formalisation is the Input Tax Credit (ITC) system under GST. This mechanism allows businesses to claim credit for the tax paid on inputs used in the production