The introduction of a >unified goods and services tax (GST) across the nation is the most important indirect tax reform since Independence. It has taken almost 16 years from the date of inception of the idea, formation of a task force, to passage in Parliament. It represents a Herculean, nationwide, multi-party consensus-building exercise which is finally bearing fruit.
The upside of GST It has huge implications. First, it addresses a serious impediment to our competitiveness. Without the GST, there are multiple points of taxation, and multiple jurisdictions. We also have an imperfect system of offsetting credits on taxes paid on inputs, leading to higher costs. Further there is cascading of taxes — that is, tax on tax. Interstate commerce has been hampered due to the dead-weight burden on Central sales tax and entry taxes, which have no offsets. All this will go once the GST is in place. It will enhance the ease of doing business, and make our producers more competitive against imports.
Second, the adoption of the GST is an iconic example of what Prime Minister Narendra Modi has called “cooperative federalism”. It represents a national consensus, an outcome of a grand bargain struck together by 29 States and seven Union Territories with the Central government. The States agreed to give up their right to impose sales tax on goods (VAT), and the Centre gave up its right to impose excise and services tax. In exchange they will each get a share of the unified GST collected nationally. The anticipated additional gains in efficiency, competitiveness and overall tax collections are what drove this bargain.
Third, once the GST is in place, it means a unified, un-fragmented national market for goods and services, accessible to the smallest entrepreneur. Companies need not maintain stock depots to avoid paying interstate taxes. This will free up some capital. All this will add to demand, and also efficiency. The National Council for Applied Economic Research and others have estimated that national GDP growth can go up by one percentage point on a sustained basis.
Fourth, because the structure of claiming input tax credit is linked to having proof of taxes paid at an earlier stage in the value chain, this creates interlocking incentives for compliance between vendor and customer. No more questions from a vendor: “Would you like that with receipt or without receipt?” Because of this inherent incentive, the total taxes paid, and hence collected, may go up significantly. This provides buoyancy to the GST. In fact, a significant part of the black economy will enter the tax-paid economy.
The potential downside All of this constitutes the upside of adopting the GST. Its roll-out represents a rare and historic political consensus. But that should not blind us to its potential downside, or the devil lurking in the details of its implementation. Here are some issues to consider.
First is the question of the uniform GST rate. What should it be? An early report of the Finance Ministry from 2003 mentioned a rate of 12 per cent. Over the years this rate drifted higher, and the focal number being discussed now is 18 per cent. What determines this number?
The empowered committee of finance ministers uses a concept called “Revenue Neutral Rate” or RNR. The RNR is that uniform rate which when applied will leave all States with the same revenue as before. So no State should lose out by signing up to the GST. But this approach is faulty, since unless we try it for a year (or more) we won’t be able to gauge the buoyancy of the GST. In trying to assuage the fears of States, the calculation of the RNR has been loaded by every possible existing tax (like entry tax, octroi, etc.). This has caused the RNR to steadily escalate upward. At one point, the National Institute of Public Finance and Policy mentioned 26 per cent. The higher the RNR (and hence GST rate), the more is its inflationary impact. This is a sure way of killing the golden egg-laying goose. A better approach is to keep the GST rate low initially, and promise to fully reimburse losing States by the end of the year. Everyone may be in for a pleasant surprise by GST buoyancy. But this tax buoyancy will stop working beyond a certain threshold (like say 18 or 20 per cent). The focus on the RNR is self-defeating.
Taxation and litigation The second issue is that the GST is an indirect tax. By their very nature, indirect taxes are regressive because they affect the poor more than the rich. India’s ratio of indirect to direct tax collection is 65:35, which is exactly the opposite of the norm in most developed countries. India’s ratio of direct tax to GDP is one of the lowest in the world, and it badly needs to expand the direct tax net. Only 4 per cent of India pays income tax, but practically all Indians pay indirect taxes in one form or the other. Direct tax rates have been falling, and indirect tax rates rising. For instance, service tax (an indirect tax) used to be 5 per cent in the 1990s and is now more than 15 per cent. The Swachh Bharat cess, or frequent increase in excise duty on petrol and diesel are all recent examples of regressive indirect tax. Unless a rate cap is adopted, the GST rate could easily drift higher, further hurting India’s income inequality. To meet their fiscal needs, it is always tempting for governments to tweak indirect taxes higher, since the work of expanding the direct tax net is so much harder. This temptation must be curbed with a rate cap.
The third issue is of tax litigation. Approximately Rs.1.5 lakh crore is stuck in litigation related to Central excise and service taxes. On the other hand the State-level VAT is administered in a way that empowers tax officials to dispose of cases quickly. Disputes involving Central taxes go though an appeal and tribunal process, and can drag on for years. But empowered staff under the Sales Tax Commissioner can dispose of valid grievances of State-level VAT payers much faster. This difference is called the “review” versus “revise” approach to tax disputes. It is important that the GST approach leans towards the more efficient State-level model.
State of the States The fourth issue in implementing the GST is the governance within the GST Council. It is a de facto council of States, along with representatives from the Union Finance Ministry. It seems that one State will get one vote, irrespective of its size. This seems unfair. An economically larger State, contributing a bigger chunk of the GST pie, should have a greater say. Similarly, the special needs of smaller States should also be heeded. For instance, the Northeast States had to be assuaged already with a lower threshold for GST exemption, because if a higher (uniform) threshold were adopted nationally, then nearly all businesses of the Northeast would become tax-exempt.
Finally, the issue of States’ autonomy. India will be a unique large democracy that adopts a nationwide GST, with virtually no taxing powers to the States. In the United States, the States have power to impose sales and income taxes. Within the European Union (EU), each member country retains fiscal autonomy, and also the freedom to breach the fiscal deficit of 3 per cent of GDP. Indeed virtually all members of the EU have breached that limit. In India, what if a State wants to undertake a special spending programme to respond to a State-specific situation, such as a disaster? In 1982, the Chief Minister of Tamil Nadu upgraded a midday meal scheme which his opponents criticised as being an empty promise and fiscally reckless. In response he raised taxes on goods (not possible in a GST regime), and made the programme so successful that it is praised to this day, not just in India but also around the world. It achieved the double objective of better nutrition for children and better school attendance. Similarly in the drought crisis year of 1972, the Maharashtra government imposed a profession tax on city dwellers (not possible under the GST) to fund an innovative programme called the rural “Employment Guarantee Scheme (EGS)”, which three decades later was acknowledged nationally as the inspiration behind the National Rural Employment Guarantee Act. The GST regime should remain sympathetic to this issue of States’ fiscal autonomy. We have not even mentioned here what happens to the third tier, i.e. local bodies.
The GST is obviously not a panacea for all ills of India’s economy. It is nevertheless a revolutionary and long-pending reform. It promises economic growth and jobs, better efficiency and ease of doing business, and higher tax collection. We hope that its imperfections and potential pitfalls will be sorted out as we roll it out.
Ajit Ranade is a Mumbai-based economist.