Macroeconomics

Goods and Services Tax in India: Challenges and prospects

  • Blog Post Date 25 August, 2014
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Govinda Rao

Fourteenth Finance Commission

mgrao48@gmail.com

The Finance Ministry recently announced that the Goods and Services Tax will soon be a reality. In this article, M. Govinda Rao – member of the 14th Finance Commission – discusses the challenges and prospects of transitioning to GST. He contends that given the multitude of stakeholders and contentious issues involved in the negotiations, finalising and operationalising the tax structure will take time, and that it is unrealistic to expect a “flawless” GST.



There is considerable expectation in India that the new government at the centre would activate the reform process to introduce the Goods and Services Tax (GST). GST is a value added tax (VAT) on goods and services as against the prevailing VAT on only goods. The important gains from the GST reform are that it is expected to broaden the tax base, reduce distortions in the economy through a more comprehensive input tax credit, enhance export competitiveness by comprehensively relieving domestic consumption taxes on exports, ensure greater regional equity by getting rid of inter-state sales tax and having a destination-based tax, and help create a seamless national market by removing inter-state trade barriers. It is hoped that the reform will significantly reduce the compliance cost for taxpayers by simplifying and harmonising the tax structure and by making the administration uniform across states.

The dual GST proposed to be introduced is expected to expand the tax bases and simplify and harmonise the conception tax systems presently levied at both central and state levels. The Central VAT (CENVAT) levied at present, has a narrow base and multiple rates. It is levied on goods at the production stage, and value added in subsequent stages is not included in the base. In the proposed Central GST, the base will be expanded by merging the service tax with the CENVAT, extended to wholesale and retail levels and simplified to have only one or two rates. The merger of service tax in GST helps to ensure more comprehensive input tax credit and relieve the tax on exports. The State GST will expand the base of the prevailing VAT to include services. The tax will be simplified by merging a number of other taxes such as motor vehicles tax, goods and passengers’ tax, entertainment tax, electricity duty and entry taxes including those levied in lieu of octroi1 . Harmonisation of tax rates and administration across states would bring about significant gain in minimising distortions and reducing compliance cost for taxpayers.

GST reform: A bullock cart stuck in the mud?

While the desirability of the reform is not in doubt, making a transition to GST involves not only considerable work but also formidable challenges. Unlike in many other countries where GST is a centralised tax, in India it is leviable by both central and state governments. This implies that both the structure and administration of the levy will have to emerge after detailed negotiations and bargaining between the centre, 29 states and the two Union Territories with legislature. Given the sharp differences in the structure of the economy and sales tax revenues (as a ratio of Gross State Domestic Product (GSDP)) across states, the interests of the states do not always coincide and considerable effort is needed to persuade them to adopt a uniform or even a broadly harmonised structure and administrative system for the tax.

Significant progress was made in arriving at a broad consensus on many aspects, until the 13th Finance Commission recommended that the states should evolve a “flawless” or an “ideal” GST (with minimum exemptions and a single rate) to be eligible to receive compensation in the eventuality of revenue loss. The states had broadly agreed on the structure of the tax and administrative system and the mechanism for relieving taxes on inter-state transactions. They had broadly agreed on the exemption list, levying the tax at two rates, and keeping petroleum products out of the GST regime. For ensuring seamless input tax credit, they had agreed on a mechanism wherein the tax levied at the stage of inter-state sale was to be collected and pooled separately and transferred to the destination state through a clearing house. They had also established the GST Network (GSTN), a special purpose vehicle with equity contributions from the technology partner (NSDL), and central and state governments to erect the information technology (IT) platform to administer GST. The Empowered Committee had also decided on a simplified system for taxpayers with turnover less than Rs. 5 million ($83,333 approx.); they were not required to maintain detailed accounts of their transactions and merely pay 0.5% tax on their turnovers. Of course, this tax is not eligible to get input tax credit and become a part of the VAT chain.

However, the 13th Finance Commission’s recommendation that states should levy “flawless” GST to be eligible to receive compensation for any loss of revenue put the entire negotiation process on the back burner. The problem was compounded by the central government’s refusal to pay compensation for the loss of revenue arising from the reduction in Central Sales Tax (CST). CST is the sales tax levied on inter-state transactions. The tax which was levied at 4% by the exporting state was reduced to 2% in 2007 in preparation for the introduction of GST. The central government had agreed to pay compensation for the loss of revenue to the states until 2010, when the GST was to be implemented. When the central government refused to compensate the states after 2010, a huge trust deficit was created and the entire negotiation process virtually broke down. The new Finance Minister has promised to clear the backlog of dues to the states and the states have resumed the the negotiation process. The Finance Minister has also announced that the Constitution Amendment Bill will be placed in the Winter Session of the Parliament. These developments bode well.

Contentious issues and negotiation process

There are a number of issues on which negotiations are necessary to reach a consensus between the centre and the states and among the states themselves. The first issue relates to the inclusion of taxes within the ambit of GST. The bone of contention relates to inclusion of purchase taxes on foodgrains, taxes on motor spirit and high speed diesel (GSD), and octroi or entry tax in lieu thereof. The foodgrain surplus states have been levying the purchase tax, the burden of which is exported to non-residents. The states are reluctant to bring motor spirit and high speed diesel within the ambit as presently the tax is levied at a floor rate of 20% and the states derive about 35% of their sales tax collections from these petroleum products.

Another issue to be decided is the rates of central and state GSTs to be levied. It is expected that the tax rates would be revenue neutral. This implies that in the short term, there would not be any revenue loss or gain, but over time, the revenue productivity is expected to increase due to better compliance of the tax and increased productivity of the economy. However, estimation of revenue-neutral rate requires consensus on the exemption list, number of tax rates to be levied and the list of goods and services to be included in different rate categories. Revenue-neutral rates have to be estimated for the centre and for each of the states. Furthermore, when there is a preference for two rates - one for essential goods and services consumed by common people and another general rate – the estimation of revenue-neutral rates becomes further complicated.

The revenue-neutral tax rates are expected to vary widely across states Therefore, convergence on common rates will not be easy. In 2011-12, the revenue from VAT as a ratio of GSDP varied from 2.9% in West Bengal to over 6% in Chhattisgarh, Goa, Gujarat and Kerala among the general category states, despite having broadly uniform nominal VAT rates, and these differences were mainly due to differences in administrative efficiency. Nevertheless, the states with high revenue-neutral rate apprehend that levying GST at uniform rates could result in their losing revenue in the long term, even if the central government agrees to compensate for the revenue loss during the first three years. One possible solution is to merely stipulate a uniform floor rate (set at average) and allow the states to levy the tax at rates at which they do not incur any loss.

The states seem to prefer floor rates rather than fixed rates for reasons of fiscal autonomy. However, there is much to be gained by having uniform fixed rates for simplicity, avoiding diversion of trade and reducing the compliance cost. The states had successfully negotiated to have broadly uniform VAT rates instead of widely varying sales tax rates in 2005, and any measure to have GST at non-uniform rates would be retrograde. It will substantially erode the benefits of reform to the economy. Persuading the states to have a uniform tax system requires the centre to agree to compensate the revenue losses. To allay the fears of the states with high effective tax rates, the centre may keep the option of discussing the structure again after gaining two years’ experience with the Empowered Committee.

Another major area for negotiation is the treatment of taxes on services with inter-state coverage. With respect to services such as transportation of passengers or goods in railways or telecom, the place of sale and payment and the place of consumption may not coincide and allocation of revenues will have to be negotiated and settled. Although general principles of allocation have been discussed and usually the appropriation is done according to place of origin, it is important to have clearly defined principles and rules for the allocation of revenues from transactions in such services.

Another area where a lot of work is needed is the setting up of an administrative system for GST and working out the transitional arrangements. Ideally, from the viewpoint of reducing compliance cost, a unified administration would be desirable. However, that is not likely to happen as each state would like to control the administration of its GST. In this situation, harmonisation of administrative processes with uniform systems, forms and procedures would be necessary. This would also require additional training of tax collectors in the administration and enforcement of the tax. Equally important is the dissemination of information about the tax to taxpayers.

Concluding remarks

Based on the experience of tax reform and the complexities involved, it is important to underline three important issues. First, given that there are 32 actors in the negotiations (29 states, two Union Territories with legislatures and the central government), it would take considerable time to finalise the structure and operational aspects of the tax. In view of this, the most optimistic scenario is that it would not be before 2016 that the tax would be implemented, even if the process of amending the Constitution is completed. Second, the tax structure that would emerge from the negotiations would be far from ideal. It would be unrealistic to expect “flawless” GST. In fact, such a GST structure does not exist in any country where both the centre and states are empowered to levy the Tax (Bird and Gendron 2010). Every country has to adopt the structure it can administer. It is neither a gorilla, nor a chimpanzee, but a genus-like primate (Rao 2010). The structure that would emerge would be based on the consensus reached and it is necessary to ensure that the fundamental, sound features of the tax are not compromised. Finally, for the above reason, it is important to consider the GST reform as a process rather than an event. Once the basic features of the tax are implemented, it would be necessary to improve the structure and operational aspects of the tax over time. In fact, the introduction of GST is only the next stage of reform. In that sense, the introduction of GST will not be a silver bullet and we should keep expectations at a realistic level.

Notes:

  1. Octroi refers to local taxes on the entry of goods into a municipal area for consumption, use or sale.

The views expressed in the article are of the author and do not necessarily reflect those of the institution to which he belongs.

Further Reading

  • Bird, Richard M and P Gendron (2010), VAT in Developing and Transitional Countries, Cambridge University Press, New York.
  • Rao, Govinda M (2011), “Goods and Services Tax: A Gorilla, Chimpanzee or a Genus Like Primate?”, Economic and Political Weekly, Volume, XLVI; February 12; pp. 43-48.
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