The proposed Goods and Services Tax Bill will mean that states like Tamil Nadu, which have manufacturing industries, will lose out on own tax revenue collections. Instead of focussing only on indirect taxation reform, the centre must also consider sharing direct tax administration with states, which has been the practice in other federal arrangements internationally.
There is finally light at the end of the tunnel for the Goods and Services Tax (GST) Bill in India. Tamil Nadu, a state with a substantial manufacturing sector, kept raising its genuine apprehensions from the time the Value Added Tax (VAT) was introduced, emphasising the revenue impact of shifting the levy of sales tax from origin to point of consumption. The Goods and Services Tax Bill will, when enacted, have a similar effect. Maharashtra, Gujarat and Madhya Pradesh stood with Tamil Nadu at different points in time, while now Tamil Nadu remains the lone consistent dissenter. Political dynamics have been influencing the positions of state governments.
Woes of Manufacturing States
For states with manufacturing industries, sharing the unified indirect tax base with the union government via the destination-based GST, will mean an outflow of tax revenue along with goods and services produced there, to states that consume the goods and services. In this sense, GST provides no incentive for manufacturing states.
The search for a revenue neutral rate (RNR) of GST may be relevant for central GST, as shifting the levy from one state to another is not going to disturb the cumulative collection of tax for the central government. But states cannot have a uniform RNR that will match their present own tax revenue trend, as manufacturing and consumption levels vary from state to state. At the same time the combined GST rate (central GST + state GST) should be fair, reasonable and not regressive. Therefore, the proposed RNR, that is, the standard rate of state GST is not going to neutralise the effects of GST on the revenue collection of all manufacturing states.
The worries of the manufacturing states have not been addressed properly by the union government. The revenue loss compensation assured by the union government for a specific period is a rocket booster, but it is doubtful that the proposed GST vehicle would launch the manufacturing states in the revenue trajectory they are travelling in now, especially after the booster runs out. If there is a failure in this mission, with no independent powers of taxation, such states may be left in the lurch.
The next major concern is that the GST distorts the basic structure of fiscal federalism provided in the Constitution. The proposed GST Council would become another institution for politicking rather than a rational think tank on indirect taxation.
Lopsided Tax Reforms
As the volume of business across the borders of the states and the nation keeps growing, the focus is more on the reforms in indirect taxation and there have been perceptible changes effected in the system of indirect tax levies in the form of Modified VAT (MODVAT) and Central VAT (CENVAT) in central excise, VAT in sales tax, allowing cross credit of CENVAT between goods and services, rationalisation of customs duties, reduction of the Central Sales Tax rate and now the GST.
No such radical reforms were attempted in direct taxes, as it mainly concerns personal income tax of local entities. Direct taxes are solely in the realm of the union government, which has shown no intent in reforming direct tax systems.
It was proposed that a Direct Tax Code (DTC) be introduced to unify and simplify the direct tax laws. The draft bill was released as early as August 2009. After much discussion on the bill, a revised bill was released in March 2014, including the draft General Anti Avoidance Rules. In the budget speech in February 2015, the finance minister explained that most of the provisions of the proposed DTC have already been integrated into existing tax law, and concluded that there was no merit in going ahead with the DTC.
The proposed reform of direct tax systems was given a silent burial.
Low Direct Tax Revenue Growth
This dichotomy in approach to tax reforms has really not done well for the public finances of the nation.
India’s tax-to-gross domestic product (GDP) ratio is at 16.6% and is well below the emerging market economy and Organization of Economic Co-operation and Development (OECD) country averages of about 21% and 34%, respectively.
The contribution of direct taxes to total tax revenue of the central government has fallen from 60.78% in 2009-10 to 51.05% in 2015-16 (provisional). The direct tax-to-GDP ratio declined from 6.30% in 2007-08 to 5.47% in 2015-16 (provisional).
In the assessment year 2004-05, only 4.87 crore people, that is, about 4% of the population have filed income tax returns with 14 lakh individuals paying 80% of the country’s individual income tax.
All these facts go to prove that there is a decline in the efficiency of income tax collections, whereas the compliance in indirect taxes is steadily increasing. No doubt, the sudden growth in service sector in the last decade has given momentum to indirect tax collections, but this growth should have been equally reflected in income tax collection, as more tax revenue from services is directly related to income. This opposite trend in direct and indirect tax collections has really hampered the overall tax-to-GDP ratio of the country.
Regressive Indirect Taxes
Indirect tax is more distributive and the GST would make the tax on goods and services completely a consumption tax. This consumption tax paid by the consumer on taxable goods and services is nothing but a “spending tax” or “expenditure tax,” similar to income tax.
One key difference is that for a consumption tax, the tax base is expenditure, not income. Everyone who consumes goods and services cannot avoid paying indirect tax, as it is built into the price. However, a majority of the population—poor and lower-middle class—consume such goods and services daily and tend to pay more indirect tax than the middle class and the rich. People in higher income groups easily avoid paying their income tax dues. This imbalanced compliance between direct and indirect tax in India makes the indirect tax regressive in nature.
Purpose of Tax Reform
Certainly, taxation should not be a hindrance to business, but the objective of tax reform cannot be confined to the demands of business alone. Tax reform is an important aspect of public finance management, as taxation is used as an instrument of attaining certain social objectives, namely, redistribution of wealth and thereby reduction of inequalities.
Taxation in a modern government is thus needed not merely to raise the revenue required to meet its ever-growing expenditure on administration and social services but also to reduce the inequalities of income and wealth. Therefore, partial tax reform to satisfy big business houses is not going to serve any purpose for the 30 crore poor people of this country living below the poverty line.
Fiscal prudence demands a matching reform in direct taxes also along with the introduction of GST to achieve a fair, equitable, elastic and progressive tax regime. A comprehensive tax reform keeping in mind the revenue requirement of the governments to meet their social and welfare objectives as well fair distribution of income, and wealth can be the only meaningful tax reform in the public interest.
Fragmentary tax reforms carried out only with business interests, ignoring the genuine concerns of state governments are likely to create major hiccups in the public finance management of the governments in the long run.
Direct Tax Reform
Income tax law in India continues to remain one of the most complicated tax laws. Complexity of the income tax law has no justification and it serves the bureaucracy alone. Such complications have only increased the cost of compliance for the assessees and cost of administration to the government.
Direct taxes are only in the domain of the union government and if there is a political will, this law can also be simplified and rationalised without much difficulty. Since the consumption tax of GST is much nearer to income tax, assessees of income may be given a tax rebate of a certain percentage of GST paid by them on their consumption of taxable goods and services. This integration of GST with income tax would complete the chain of the audit trail and make the whole taxation system more self-enforcing.
Stabilisation of the present income tax law cannot be the ground for shelving the idea of DTC. If the same logic is applied, the indirect laws of the Centre and States have also been well established and there may not be a need for GST.
In June this year, while addressing tax officers in the first ever Rajasva Gyan Sangam, the prime minister sought to double the income tax base to 10 crore assessees. Taking a cue from this, there should be a serious attempt to review the efforts towards direct tax reforms either through the DTC or in any other manner, as we cannot remain silent spectators to large-scale tax evasion when the need for revenue is more than ever before.
Share the Direct Tax Base with States
GST is essentially a consumption or expenditure tax. Income and expenditure are related and there should be routine functional coordination between direct and indirect tax administrations. When both the centre and the states agree to share the indirect tax base, the direct tax base can also be shared between the two. This would widen the direct tax base and improve the level of compliance as income earners are monitored by both agencies with reference to their consumption of goods and services.
In the European Union (EU), from where we have borrowed many components of GST, direct taxation remains the sole responsibility of member states. However, the EU has established some harmonised standards for company and personal taxation, and member countries have taken joint measures to prevent tax avoidance and double taxation.
In Canada, another prominent federal nation where VAT has stabilised, both the federal and provincial governments impose income taxes on individuals. The federal government charges the bulk of income taxes, with the provinces charging a somewhat lower percentage, except in Quebec. Quebec administers its own personal income tax system.
In the United States, the federal government, most states, and some local governments levy income tax.
Following these international models, the Government of India also may share the direct tax base with willing states with due modifications to the devolution formula. This idea was mooted by the present Minister of Defence, Manohar Parrikar, when he was the Chief Minister of Goa in the beginning of 2014. Now a rethinking has to be made on this important matter by the union as well as state governments.
Need for Public Interest in Tax Reform
Despite high economic growth, India ranks 130th in the Human Development Index of 2015, below Malaysia (62), Sri Lanka (73), Mexico (74), China (90), Egypt (108), Indonesia (110), Philippines (115), South Africa (116) and Namibia (126).
It is said that we are going to gain additional GDP growth of 1% to 1.5% thanks to the proposed GST. Balanced growth in production as well as consumption could lead to sustainable growth. Without increasing the consumption power of a majority of the population, India cannot achieve sustainable economic growth. Therefore, tax reforms should not be aimed only at increasing production. Instead, the reforms should be aimed at augmenting revenue to assure alleviation of poverty and creating a more equitable society.