How to get GST right: Not factoring in low rates will lock India into high rates


If rates are kept low, compliance will increase—not factoring this in will lock India into high rates.

Finance minister Arun Jaitley makes a strong point when he says those opposing the cess he is proposing to compensate states in the GST structure haven’t understood this is actually better than a tax. For every R100 levied as a GST tax, the Centre will get only R50, and 42% of this has to go to the states, leaving the Centre with only R29—so, to compensate the states by R50,000 crore, it will need to levy a tax of R172,000 crore! Put that way, there can be no doubt the cess is better than the tax. Of course if, as is expected, half the cess is going to come from the one on energy, this adds a considerable cost to the system since energy is an input and the cess cannot be adjusted as a credit.

Jaitley also defends the multiple GST rates by arguing that if there were a lesser number of rates, many items that are currently taxed at around 5-6%—most of them are exempt in the central list but face a state VAT right now—will see a big jump in prices if the tax is fixed at, say, 12%. Former finance secretary Vijay Kelkar has, along with Satya Poddar and V Bhaskar in a column (GST: Make haste slowly, October 19, Mint) argued the GST rate can be higher on certain items—that is, the exemptions can be reduced—and certain sections of the population can be compensated for the higher GST payout on their consumption basket through a direct benefit transfer (DBT), but targeting is not that easy.

Also, while it may be desirable to have a single-rate GST from the point of it being simpler, it is important to keep in mind that the political economy is such that the best solution doesn’t usually win. In such a case, then, the reformers’ job is to try and push for the least-bad solution. And this is where, it appears, the finance minister is not being ambitious enough and not taking into account the benefits of the GST.

What we need to focus on is the fact that, based on the proposal given to the states by the finance ministry, the revenue-neutral-rate of GST is working out to be around 17-18%, which is considerably higher than the 15-15.5% that the chief economic advisor (CEA) recommended as being non-inflationary.

While the revenue department of the finance ministry argues that this is also because the CEA’s calculations were based on taxes collected in an earlier year—the new tax proposals are based on the actual taxes of R8.8 lakh crore collected by the Centre and the states in FY16—this is neither here nor there; by this logic, tax rates will keep going up each year in order to catch up with the amount of tax needed/collected.

What makes tax collections go up even when the rate is fixed is the increase in nominal GDP itself and compliance—the amount of the potential tax base that actually pays taxes. While India’s compliance rates across the GST chain are estimated to be around 35-40%, with the biggest evasion taking place in service taxation, it is obvious that a higher compliance will come with the complete goods/service value chain being captured and lakhs of tax invoices being matched in real time by powerful and smart computer systems—based on the taxpayer number, for instance, the computer will track any good, and the tax paid on it, from the first producer to the last, so if the chain breaks at any point, the taxman will know whom the good has been sold to and will be in a position to identify where the tax evasion is taking place.

But any system, no matter how good, can be compromised, particularly if the entire chain operates in cash and that is why a lower rate is a good idea—as in other areas of taxation, this too will encourage compliance—since getting the system to stabilise will take time as every trader/producer will have to input item codes for thousands of items.

Moreover, in the current list circulated, more than a fourth of items are to be taxed at 26% and these include many items of everyday use. While the best would be to abolish the 26% slab and move all these goods to an 18 or 20% slab, if the rate has to be retained for revenue reasons, the best bet would be to drastically prune the list in the 26% slab to just a few items.

The critical issue here, again, is one of compliance. The CEA’s analysis had concluded that increased compliance could fetch additional revenues of R4.3 lakh crore or around half the amount collected in FY16. It is not clear what level of compliance needs to be achieved to get to this figure, and how long it will take to get to the required levels of compliance, but it is obvious the results of compliance can be a game-changer.

There is a related problem here which finance minister Jaitley needs to keep in mind. If not in the first year, certainly everyone expects compliance to go up after 3-4 years. If so, what that means is the Centre and the states will see a huge jump in their tax collections—since the chances of the political class saying it will cut tax rates as it needs far less taxes are remote, keeping a high rate now means India will get locked into a perpetually high tax regime; if the VAT experience is anything to go by, once the political class found the system was working well, it hiked VAT rates instead of reducing them. And while it is possible for the finance minister to say the GST Council can lower rates once there is increased compliance, doing so will be difficult since the structure needs a real champion to push for lower rates and, unlike today where states are looking at a step-up in revenues, there will be no carrot to dangle at them later.

But, an argument will be made, the efficiency gains will be in the long run while the tax compensation will have to be made every quarter—how is the mismatch to be handled? This is where the new FRBM committee under NK Singh comes in. If a path-breaking taxation is to be introduced and can be compromised by putting in place a high rate-structure just to meet temporary shortfalls, surely the committee can be persuaded to relax the FRBM by a certain amount for 3-4 years, to allow for this—if this is done, Jaitley’s point about needing to compare the R50,000 crore cess with a potential R172,000 crore tax becomes moot since the FRBM will allow the compensation to be paid for through a higher deficit. Just as the promise of a 100% compensation was meant to assuage the fear of states and get them to agree on GST, relaxing the FRBM should allow the Centre to take a bolder approach to GST. If the sole purpose behind the proposed GST is to levy tax rates roughly similar to those in place today—and that is what it looks like right now—you have to ask yourself whether it is even worth it.


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