A grand tax bargain in danger of coming apart

A Goods and Services Tax version 2.0 may have to be designed soon given the flaws in the existing structure,

August 05, 2021 12:02 am | Updated December 04, 2021 10:30 pm IST

Government Tax - GST Guide Book  - Illustration as EPS 10 File

Government Tax - GST Guide Book - Illustration as EPS 10 File

After four years, the promise of the Goods and Services Tax (GST) remains substantially unrealised. It is a far cry from the attempted avoidance of cascading and continues to be a not very transparent multi-rate system with associated difficulties in computing and assessing tax liability, tax burden and tax incidence. States have less headroom in handling GST collection shortfall after surrendering their fiscal autonomy. When the period of five years of compensation ends in 2022, will we see a continued flawed system or a freshly minted GST 2.0, given the asymmetry of the power equations between the States and the Centre?

The tax base of GST does not appear to be expanding as the recent uptick has reversed last month. The GST is strongly co-related to overall GDP. Revenue collection of the GST is dependent on the nominal growth rate of Gross Value Added (GVA) in the economy. Since inception, GVA per quarter has been between ₹40-lakh crore to ₹47-lakh crore and GST revenue has not been higher than ₹2.7-lakh crore to ₹3.1-lakh crore. The Tax to Gross value addition is only about 5% to 6.5% though GVA growth was much higher. Obviously, a very large segment is covered by exemption, composition schemes, evasion and lower tax rate.


Centre holds the cards

The fundamental weakness of the GST is its political architecture which is asymmetrically loaded in favour of the Centre. Disputes between States and between the Centre and the States are inevitable in a mosaic arrangement. But in the current structure, no particular body is tasked to adjudicate this though the original Constitution (115th Amendment) Bill 2011 (GST Bill) had a provision for such an institution. In the voting, the central government has one-third vote and States have two-thirds of total votes (with equal voting rights regardless of size and stake). With the support of a dozen small States whose total GST collection is not more than 5% of the total — and their Budget is mostly underwritten by the central government — the game is hugely in the Centre’s favour. With equal value for each States’ voting, larger and mid-sized States feel shortchanged.

Severe fiscal strain is expected when the 14% compensation comes to an end as the median growth rate of subsumed taxes is only 11%, and in many States between 5% to 10%. The median subsumed tax buoyancy is below unity. This means with 1% growth, there will be a 0.75% growth of tax. The contraction of GST revenue across the country means that the compensation amount will be higher and the clamour for a continuance of compensation scheme is inevitable.

Issues with tax structure

The second problem is the design flaws in the tax structure. Nearly 45% to 50% of commodity value is outside the purview of the GST, such as petrol and petroleum products. In addition, States which export or have inter-State transfers or mineral and fossil fuel extractions are not getting revenue as the origin States and need a compensation mechanism. The pre-existing threshold level of VAT has been tweaked too often which has led to an evaporation of tax base incentivising, enabling evasion and mis-reporting. Most trading and retail establishments, (however small) are out of the fold of the GST. At the retail level, irrespective of whether Input Tax Credit (ITC) is required or not, the burden can be passed off to the consumer. As a result, the loss could be as high as one third.


Third, exemptions from registration and taxation of the GST have further eroded the GST tax base compared to the tax base of the pre-existing VAT. Exemptions are purely distortionary and also provide a good chance to remain under the radar, thereby directly increasing evasion or misclassification. Theoretically, exemptions at the final stages reduce tax realisation. As multiple rates are charged at different stages, it goes against the lessons of GST history. This tax works well with a single uniform tax rate for all commodities and services at all stages, inputs and outputs alike. While most countries have a single rate, India stands out and is among the five countries to have four rates/slabs.

Exclusion as another issue

The fourth is that of exclusion. Petroleum products remaining outside the purview of GST has helped the Centre to increase cesses and decrease central excise, in what would otherwise have been shareable with the States. Now, States will be keen on including petrol and diesel under the GST as their share of tax goes up in the process, even if there is a special rate fixed for it.


In April 2017, cess and surcharge formed 56% and 35% of the excise duty on petrol and diesel, respectively. Now, their share has increased to 91% and 85%, respectively, and the shareable central excise has reduced by ₹6.5 a litre, making it ₹2.98 for petrol and ₹4.83 for diesel. Equity requires that petrol and diesel be brought under the GST . Apart from the complexity it creates in record keeping and ‘granting ITC’, in the present form it also leads to a cascading which the GST avowedly tried to avoid.

Fifth, compliance with GST return (GSTR-1) filing stipulation and the resultant tax information is not up to date. The gap in filing GSTR-1 was 33% in 2019-20 and has been increasing. As per GSTR-3B, the effective tax rate is as low as 6.5% when GSTR-1 shows an average 15% tax rate. Fraudulent claims of Input Tax Credit (ITC) because of a lack of timely reconciliation are quite high though it has come down by two thirds. Tax evasion, estimated by a National Institute of Public Finance and Policy’s paper, is at least 5% in minor States and plus 3% in the major States.

These policy gaps with regard to a higher threshold (when in sales tax, it was lower) exemption level and multiple tax rates have led to a base erosion. Policy gaps along with compliance gaps do need to be addressed. Without proper tax information, infrastructure and base, the States would go in for selective tax enforcement. In the long run, voluntary compliance will suffer and equity in taxation will be violated. Finally, the grand bargain will come apart. Given all these problems, a version 2.0 of GST may have to be designed sooner rather than later.

Satya Mohanty is a former Secretary to the Government of India

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