The proposal departs from the expert view that an ideal GST should have a few exempted commodities and a single rate for all commodities
The GST (goods and services tax) council will meet next week to take the final decisions before the GST laws can be put in place. These include the all-important assignment of commodities into the different rates that have been agreed. If agreement is reached, there is a good chance that the GST can come into force soon.
A good GST was expected to yield major economic benefits, adding 2 percentage points to the growth rate. Unfortunately, what is on the table will not deliver that result, though it will be an improvement on the present system. It does achieve the objective of creating an indirect-tax system in which both the Central and the state tax on any single commodity will be levied on the same base, and at the same rate throughout the country, while observing the value-added tax (VAT) principle of full set-off for earlier-stage taxes and zero-rating for exports. Other taxes like the Central sales tax, octroi, entry tax, etc., will be abolished. From a taxation perspective this creates a single national market for each commodity.
The GST will also address the complaint of domestic producers that they are at a disadvantage compared to imports, because the latter escape the burden of state taxes, although they do pay an additional duty equal to the Central value-added tax (Cenvat). Once the GST is in place, imports will be subject to GST at the same rate as domestic products, thus ensuring a truly level-playing field for domestic producers competing against imports.
Unfortunately, the GST being proposed departs from the expert view that an ideal GST should have a few exempted commodities and a single rate for all commodities. Lest such an ideal be dismissed as academic, let us consider what countries actually do. According to the International Monetary Fund (IMF), 152 countries have now adopted the VAT, and of these, 69 have a single rate, with some exemptions. Admittedly, this means as many as 83 countries have multiple rates, but they don’t have anywhere near the number of rates we are considering.
The average number of rates for high-income countries is a little over 2.2, but this is because the European Union has multiple rates, which it is considering converging to a single rate. The average number of rates for lower middle-income countries, which is the relevant comparator group for us, is only 1.7. Against this, the GST council has approved four rates: 5%, 12%, 18% and 28%, with a number of essential commodities to be excluded. Some luxury and other commodities are expected to bear cesses which will not be shareable, and which will be used to cover the compensation that the centre has agreed to pay to the states to offset any shortfall from a 14% growth in state-tax revenue. If commodities bearing cesses are treated as a separate group, the number of rates becomes five, making India a complete outlier.
The expert committee under Arvind Subramanian had recommended a standard rate of 17-18% for most commodities, a lower rate of 12% for commodities more commonly consumed, and a higher rate of 40% for luxury products like cars, and demerit goods like tobacco and paan masala. With three rates plus an exempted category, we would still have had more rates than the average, but this would have been an acceptable outcome as a start. The Union finance ministry proposal to the GST council increased the number of rates to four i.e. 6%, 12%, 18% and 26%, plus cesses on some of the commodities in the 26% slab. The GST council, in its wisdom, worsened the situation by widening the spread, lowering the lowest rate to 5% and increasing the highest to 28%!
Does this matter? The answer is a definite yes. The merit of a single rate is that tax evasion can only occur through “under declaration” of sales, which is more easily tracked, especially as we move towards electronic payments systems. Multiple rates create incentives for deliberately mis-declaring items so they fall in a lower-rate slab. Inevitably, this creates scope for tax disputes and harassment/corruption. The proposal approved by the GST council will multiply this possibility.
Multiple rates were probably adopted to make the least difference to the tax rates currently applicable to different commodities, in the hope that post-tax prices of most commodities will not change, or change very little, after the GST is implemented. This was a wrong objective. We should accept that the GST will bring about some post-tax price increases for some individual commodities, which will be offset by the lower prices of others. The aim should not be to leave individual prices unchanged, but to leave the overall level of the consumer price index (CPI) affected as little as possible. In any case, the prices of individual commodities change because of a number of factors regardless of whether we change tax rates or not. Besides, a more efficient tax system yields other benefits in terms of improved compliance and promotion of efficiency, which is expected to increase growth and, hopefully, also employment. These benefits have been sacrificed at the altar of “no price change”.
Part of the problem arises because as many as half of the commodities that figure in the consumption basket are likely to be exempted. While this may be applauded in some quarters as pro-consumer, what it actually does is to force other rates to be much higher to ensure revenue neutrality. That in turn leads to the desire to introduce more gradation, with lower slabs at one end and even higher slabs at the other. There is a strong case for cutting the excluded list down to 25% of the commodities in the consumption basket, and thus mitigating high rates on the items at the other end of the spectrum.
Three exclusions from the GST are especially indefensible. These are electricity, real estate and petroleum products. It has been agreed that petroleum could come into the GST list at the end of five years. A similar agreement is necessary for electricity and real estate. Extending the GST to real estate would encourage investment since real-estate development is an important part of fixed capital formation. At present, taxes paid on construction inputs, including steel, cement, paint, doors and windows, etc., cannot be credited against the GST to be paid on output from the factories/offices generating taxable goods and services. Bringing real estate under the GST would help these activities. It will also help to discourage the use of black money in real-estate transactions.
It may seem that nothing can be done at this stage but that would be incorrect. As an immediate measure, the GST council could announce that it is open to considering changes based on suggestions that may be made when the law is debated in Parliament. Business associations have not yet expressed a view. They are obviously waiting to know the tax rates that will be applied to different commodities. Once this is known, we can expect a flurry of representations, mostly arguing for being grouped in a lower-rate category. Most of these requests may not be acceptable but what can be considered are shifts which (a) reduce the danger of misclassification or (b) are matched by upgrading other items to higher rate categories.
There is concern that the law may include provisions relating to “unjust enrichment”, i.e. a failure to pass on the benefit of tax changes to the consumer. These could become a nightmare in administering the system and a source of harassment. The views of tax practitioners on the details of the law should be considered carefully to ensure that the GST law does not contradict the objective of improving the ease of doing business.
Looking beyond the changes that could be made based on immediate representations, the GST council could announce that the structure being put in place now will be reviewed on the basis of experience of the first two years, and an effort will be made to move to a three-rate structure with a smaller list of exemptions to be presented for the fiscal year 2020-21. This review should be conducted by an independent secretariat, which will assist the GST council.
The GST council is a new innovation, reflecting the move to cooperative federalism. It is also an extremely important body since any future change in GST rates, or in the commodity classification, will only be possible with the consent of the council. If we had a tax structure that was perfect, and changes were only expected to be made rarely, and if states were well-equipped with technical capacity, there may have been less need for an independent secretariat. If, on the other hand, we view what has been agreed as a start, and hope to work towards a better structure over time, a high-quality independent secretariat is essential.
The secretariat should be headed by an Indian Revenue Service officer who should enjoy the rank of secretary and report to the council through the Union finance minister. It should be staffed with revenue service officers from the Centre and the states and chartered accountants and economists. It should put out discussion papers in the public domain, addressing concerns that different groups have, and also interact with these groups. It should also provide professionally high-quality responses to specific questions which the Centre and the states want examined. This function is particularly important because most states do not have the capacity to do this on their own. The finance ministry has the capacity, but it cannot be regarded as an independent entity.
Announcement of the establishment of a permanent secretariat as part of the GST law would send a major signal of seriousness in the tax-reform effort. If getting agreement on these proposals delays implementation a little, that should not deter us. The deadline of 1 July is much less important than getting it as right as possible. After all, we have waited 13 years since the GST was first proposed in 2004! A few weeks more won’t matter.