GST: indirect tax regime to focus on unified framework

Dated 24th August, 2014

Ad man Rory Sutherland of Ogilvy and Mather in a TED talk entitled Sweating the small stuff, refers to a strange disproportionality where the response of a target audience is inversely proportional to the force applied.

While inflation, the revenue deficit, labour reform and subsides remain important macroeconomic issues that the government should focus on, economic reform should now be about the small stuff. The list of such “plumbing” reforms is long. Each item, in turn, requires a laundry list of enabling actions. These small-ticket reforms range from getting the corporate bond market off the ground; to establishing a workable bankruptcy regime; to cleaning up public sector banks; to implementing a nation-wide goods and services tax (GST). This column, over the year, will address several of these issues.

Of these, GST is the “small” reform with potentially the biggest impact. GST is little understood by the average citizen. In simple terms, GST is a value added tax (VAT), which means that each supplier in the supply chain of the product or service pays to the government the difference between the tax they charge their downstream customer and the tax they paid for the input. The only entity that does not get this offset is the final consumer of the product or service. This is the reason why GST is called a consumer tax. France was the first country to adopt this in 1954 and now derives over 50% of its total tax collection from this system. Twenty-nine of the thirty Organisation for Economic Co-operation and Development countries levy a value added tax. The only exception is the US. GST rates in these countries vary from a low of 5% in Japan to a high of 25% in Denmark.

India has moved beyond the debate on whether to have a VAT regime. The widely applicable federal service tax framework already operates on a VAT basis and is charged at 12.36%. Manufactured products operate under a VAT regime that is either 4-5% or 12.5-15%. Yet, many indirect taxes remain outside a national VAT framework and in the hand of the states. Of these, entry tax, octroi, stamp duties, entertainment and luxury taxes are the most important. These tax rates vary widely among states and substantially impact not merely the profitability of services but often their very viability. For instance, Maharashtra taxes cinema tickets at nearly 50% whereas Goa does at 25% and Tamil Nadu levies 15% (though prices are capped). Similarly, expensive hotel rooms are taxed at 12% in Karnataka, 15% in Maharashtra, and 25% in Tamil Nadu.

GST combines all these value added taxes into one framework and attempts to apply understandable and easy to follow rates and processes. This unified framework will reduce the friction in transport and delivery of goods and services across states in India. Much of this framework has already been hammered out in discussion between the central government and states over the last five years.

Some sticking points have prevented the consensus required to pass a required constitutional amendment. The main points of departure relate to the exempt list, those items to be exempted from the GST framework; the issue of compensation for taxes lost by states in the initial period and a somewhat technical point about dual centre/state control on small businesses. Pundits have proposed two general solutions. One set has suggested a compromised birth—do whatever it takes to get it done is their mantra. The other set has suggested that it is better to take some time and do it “right” rather than compromise at the start.

I suggest that both approaches be adopted though for different issues. On the matter of exempt items, I think it is important that the drafters of the Bill draw a hard line and ensure that the state and central lists are identical. In addition, only liquor (which has previously been agreed) should be exempt from the framework altogether whereas items such as petroleum products which have been reintroduced in the exempt discussion should not be allowed. In legislative matters, India has too often compromised at the get go resulting in great difficulty later. On the matter of compensation, I think the central government should be more accommodative and protect state revenues for longer. This is a tactical decision and should not be made part of the constitutional amendment. The arcana surrounding the issue of dual control should be demystified; states should have both administrative and legal jurisdiction for small firms. With more and more states being governed by Bharatiya Janata Party (BJP) governments, there is every likelihood that the winter session of Parliament will allow passage of the constitutional amendment Bill for GST. It will be one small step for the legislature but a giant step for the benefit of the country.