Seventeen years after its framework was formed, India’s biggest tax reform – the goods and services tax – was rolled out on 1 July 2017. Some consider the ‘one nation, one tax’ system to be a game changer; some are opposed to it; almost everyone has questions around its working and how it affects them. This explainer seeks to demystify the GST.
The Goods and Services Tax (GST) has been heralded as a game changer. But few understand why. The media is full of very diverse views on GST. Even experts seem divided. Some say that it will greatly simplify the tax structure and make life easier for businesses. Some say that it is going to be a nightmare for small businesses. The proponents claim that it will improve tax compliance and widen the tax base. The opponents doubt it. The government has touted it as a triumph for federalism while the critics have condemned it as an abrogation of the states’ rights. Most people are aware that this is a big change but are unsure about what it is meant to accomplish and how it will affect them. Hopefully, this explainer will help answer your nagging questions.
But first let me clarify the rationale for GST to set the stage for further more perplexing questions that we will keep for the experts.
There is little dispute that the present system of indirect taxes in India is messy, inefficient and wasteful. Both the central and state governments collect a large number of taxes. Most important taxes legislated by the central government are: Central Sales Tax (CST) on interstate sales of goods, Excise tax on manufactured goods, and Service tax. State governments levy: VAT (Value Added Tax) on goods produced and sold within the same state, Entertainment tax, Luxury tax, Octroi or Entry tax, and a tax on the transport of passengers and goods. Often a business has to pay multiple taxes to different government bodies. This makes tax compliance difficult. GST is meant to simplify tax payment for the payers as well as the collectors as it would replace all these taxes under a centrally coordinated tax collection system.
Octroi, as an important source of revenue for municipal corporations in Maharashtra, has been notorious as it is prone to corruption and bears major responsibility for the long line of trucks stopped at the city gates to pay this entry tax. This is extremely costly and adds to the costs of goods. GST would get rid of this wasteful tax.
In addition, GST is a value added tax. The mechanism of tax collection would establish an information trail making cheating more difficult. How would this work? Consider the following supply chain: Cotton farmer – trader – textile mill- garment factory – store – customer. The final price at which a consumer buys a garment will be the sum of all the value added and all the taxes paid by each link along the way. This means that all the tax finally comes out of the consumer’s wallet. Yet, each link plays its part in charging and passing on its own component of tax according to the value it added toward the final price of the garment paid by the consumer. Consider a link in this supply chain, say the store. Suppose a garment is sold for Rs. 1,180 to the consumer. The store bought it for Rs. 900 from the garment factory, added a value of Rs. 100, and the GST rate is 18%. The store-owner will send to the government full Rs. 180 tax but would claim from the government a credit of the tax (= 18% x 900 = Rs. 162). This way s/he will have fulfilled their responsibility of doing their part in the tax collection; s/he will have sent a net tax of Rs. 18 (=18% of Rs. 100) on the value he added along the supply chain. But now you see that built into this scheme is the incentive for each link in the supply chain to demand a computer or paper record of the previous transaction. This helps informal transactions become formal and come under the tax net and, hence the claim that GST will widen the tax base.
It would be natural to wonder that if ultimately it is the consumer who would pay the entire GST, why not just have a sales tax at the last stage of the supply chain (that is, store to the consumer)? Why bother having all these intermediate stages pay taxes and ask for credit, etc.? The problem is that many goods are both final and intermediary. Consider for instance – cloth. The final consumers can be both garment factories and households. Many goods are like this. Flour can be an intermediate good to a bakery or a final good to a household. Or, a hammer or a screwdriver, and so on.
What about a turnover- or transactions-based tax? Would it not be simple to have one tax rate on each transaction? That would have an exactly the opposite effect as a value added tax. First, that would mean cascading of taxes generating a totally irrational system. The traders at the end of the supply chain will be paying a lot more tax than those at the beginning. Also, if each transaction is taxed, it would create incentives to hide all transactions from the tax authorities and unlike in the case of GST the interests of all the links in a supply chain would be aligned. In fact, it would create incentives to have vertical integration so that all transactions are subsumed within one business firm even if it is not warranted by efficiency consideration.
Presently, every state has its own set of taxes and that makes interstate movement of goods and services very cumbersome. A big advantage of having one uniform tax across the whole country is that it would make India into one integrated market which, in turn, would make it a competitive market. That would ensure that the most efficient firms would survive and consumers would benefit.
These are the intrinsic merits of a value added tax like GST and this is why 160 countries across the world have adopted some form of it. Yet, while agreeing with these basic merits of a value added tax like GST, the specific form that the GST in India has taken has come under scathing criticism. Why?
First volley of criticism has come from those who point out that the key advantage of a value added tax of this sort was supposed to be its simplicity for the payers and for the collecting agencies, and the proposed structure for GST in India is far too complicated to claim that advantage. Singapore, for example, has one rate of 7% for all goods and services while India has five rates ranging from 0%, 5%, 12%, 18%, and 28% according to where a particular good or service fits on the spectrum from needs to luxuries. Multiple rates would lead to legal challenges and bribery. Of course, the most obvious reason for the multiplicity of tax rates is to bring in some measure of progressivity in an indirect system of taxes. However, critics are still puzzled why there had to be five rather than say three rates.
However, unlike Singapore, India is a federal State and the central government is constrained by the Constitution to take into account the varied interests of different states. The reason why it has taken so long to hammer out this Bill is precisely because it needed an agreement with 29 states, and it also needed some constitutional amendments. Several issues that have been pointed out as deficiencies in the Bill are mostly compromises that the central government had to acquiesce to. For example, certain items (example, alcohol, petroleum, real estate) are kept outside the GST coverage presumably due to the insistence of the states. Also, something like real estate is a major source of tax evasion and corruption. Gold bullion is also surprisingly marked as a low tax item. Critics think that all these compromises have made it into a flawed Bill.
GST Council has been set up to coordinate issues arising between the Centre and states. If the states have to give up on their own taxes, they need to be compensated adequately. Though it has never been made clear, there seems to be a general understanding that GST on a particular good or service will be split equally between the Centre and the destination state (where it will be consumed). This should ensure some uniformity of tax rates at least for the same good across the country. But critics fear that the GST Council is only an advisory body. Even if they start off having the same SGST (state GST), if a state wants to increase the tax rate later, it could invoke the Constitution to deviate from the previously agreed rate with the GST Council. If that happens, the idea of a uniform tax creating one integrated market would break down. As it is a firm with operations in many firms has a nightmarish job of registering and filing tax forms in each state. The task is compounded by having to file three forms every month. “Why would you call this a simplification?”, ask the critics.
The Bill has created some panic in India’s informal sector, and indeed that is where much of India’s economic activity takes place. Most business units in India are family firms that keep no formal records of their transactions leave alone digital records. How will they register or file their returns? The government’s answer is that any business with a turnover of less than Rs. 2,000,000 is exempt from having to register for GST and since most farmers and these small family businesses are likely to be operating below the line they do not have to have to worry. Is the government justified in making this claim?
Some have pointed out the so-called ‘missing trader problem’. If one trader in the supply chain opts to not file his/her taxes, the next link in the chain would get no credit for the purchased inputs and this would mean they would be bearing the burden of paying the taxes for the absconder. This possibility might induce them to stay out of the GST system and if all the links in the supply chain entertain such a possibility they would all opt out and the system could unravel.
Many believe as they did with Aadhaar1, that it is always prudent to first experiment on a small scale, iron out the bugs, and then expand. They feel that the way the government has embarked on it has the potential to cause a huge mess and resentments witnessed during the demonetisation. Are we really ready for GST in 2017?
There are some unsubstantiated claims on either side about the impact of GST. For example, some proponents have claimed that the prices will go down while some opponents have claimed the opposite. The government’s avowed intent was to make a revenue neutral change. If so, there is no reason why the general price level would go up or down. Some prices will go up and some will go down. Of course, removing the inefficiencies caused by Octroi might result in some cost saving.
It is also not clear what is the basis for the claim that GST will boost the growth rate. One can only conjecture that it must be based on the assumption that the ease of tax payments would spur entrepreneurial activity.
The most contentious questions are the questions of judgment for which I don’t have ready answers. I leave them for the experts.
- Has the Bill infringed on the states’ rights or, on the contrary, has it made far too many compromises for the sake of accommodating the states’ demands and weakened the intended advantage of making the tax system simpler?
- Will the announced exemption for firms with a turnover below Rs. 2,000,000 ensure protection of the informal sector? Will it create perverse incentives to keep business units small just to avoid taxes?
- Is the claim that the tax reform under the new GST Bill will give a boost to GDP (gross domestic product) growth justified?
- What is the justification for giving a special status to gold bullion with a tax rate of only 3%?
- What is the justification for keeping real estate and alcohol out of the Bill?
- Who will gain and who will lose as a result of this tax reform?
- Should we expect the tax system to evolve gradually into a simpler system?
- Is India ready for the introduction of GST?
In the next two posts, Kavita Rao (Professor, National Institute of Public Finance and Policy) and Arvind Datar (Senior Advocate and reputable legal scholar) will respond to these questions. These will be followed by a post by Aprajit Mahajan (Associate Professor, University of California, Berkeley) and Shekhar Mittal (Ph.D. Candidate, UCLA Anderson School of Management) in which they outline some of the features of GST that attempt to address challenges faced in implementing a VAT system in India.
1. Aadhaar or Unique Identification number (UID) is a 12-digit individual identification number issued by the Unique Identification Authority of India (UIDAI) on behalf of the Government of India. It captures the biometric identity – 10 fingerprints, iris and photograph – of every resident, and serves as a proof of identity and address anywhere in India.