Satya Poddar: Cleaning up with the GST

Dated 16th October, 2014

The prime minister's call for a "Swachh Bharat" is inspiring - but it cannot be limited to outer cleanliness. It must also aim at cleansing India's institutions and systems. The much-awaited goods and services tax, or GST, has the potential to reform the tax system by cleansing it of the squalor that currently besets it. However, this can be achieved only if the state finance ministers currently engaged in discussions on the GST design agree to have a clean and comprehensive tax system.

Two eyesores in the current GST design are the exclusion ofland and liquor from the GST. These sectors are characterized by significant opaqueness, corruption and domination by "goons and mafia", as alluded to by the prime minister.

Land is a breeding ground for corruption and a storehouse for illegal money. A transparent and clean system can be achieved if the GST applies to all goods and services. The seamless coordination between the central and state administrations, and the improved intelligence and monitoring under the GST would provide a better audit trail, plug revenue leakages and reduce tax evasion. The GST will also provide an automatic mechanism to cross-verify the sales declared for the GST with those declared by industry for claiming input tax credit for the real estate acquired for use in business.

The states want land (and real property) excluded from the GST on the grounds that it is already subject to stamp duty and registration fee. This is not a valid reason. All transactions are subject to income tax, but that's no reason for excluding them from the scope of the GST. So what is so special about the application of stamp duty and registration fee? Countries such as Australia, Canada, Singapore and New Zealand apply the GST to land and real estate even though they are also subject to land transfer taxes. Application of the GST will help in better reporting of transactions for stamp duty and registration purposes, which are otherwise grossly undervalued.

One of the most complex aspects of taxes is the treatment of works contract, and land and real property. Currently, such transactions are broken into three parts - the value of goods and materials, the value of services and the value of land. The states apply value-added tax, or VAT, to the goods portion and the Centre taxes the services portion, with no explicit tax on the transaction value of land. This division is arbitrary, complex and subject to manipulation. It has also been a subject of extensive litigation. For example, the courts have ruled that the agreement to purchase a flat or apartment prior to its construction is a works contract and can be subject to the state VAT and the Centre's service tax.

By contrast, if the sale agreement is entered into after the completion of construction, it is not considered a works contract and is subject to neither VAT nor service tax. To overcome the complexities of isolating the three components in the value of real property transactions, states such as Maharashtra and Andhra Pradesh have implemented a composite tax at a reduced rate on the entire value of the purchase price of the flat. If land is excluded from the GST, such complexities and arbitrary distinctions will continue. So will the opportunities for tax avoidance through manipulation of various components.

Exclusion of land will give rise to other complexities. Disputes have arisen about whether erection of cell towers is manufacturing of goods or construction of real property. Underground fibre-optic cables could be treated as goods, or real property depending on whether they are inserted in a duct/pipe, or buried directly. Plant and machinery permanently attached to the factory floor would be real property, but goods otherwise.

If land is excluded from the GST, industries would be denied the right to claim credit for the taxes applied on inputs to construction of factories, offices and infrastructure (that is, roads, bridges, storage tanks, cell towers). This would lead to cascading of taxes and increase in the cost of manufacturing in India, which is not conducive to the "Make in India" objective of the government. Imported goods manufactured abroad would be free from the burden of such cascading taxes and would have an advantage over those produced in India.

The same arguments apply in the case of liquor. Exclusion of liquor from the GST would only perpetuate the illicit trade and harmful cartels that currently pervade the industry. According to media reports, Gujarat alone records an annual turnover of Rs 30,000 crore from illicit liquor trade. Tamil Nadu is another place where illicit liquor sales are a thriving business. The nation-wide figures would be colossal. What better opportunity than the GST to bring transparency to the sector? If the GST applies to liquor, it will significantly reduce tax evasion through more efficient transactions tracking and improved enforcement and compliance. The states need not fear the loss of revenue, as they will retain their exclusive powers to legislate on matters relating to liquor and to levy excise duties, licence fees, and sales and purchase taxes over and above the GST. Also, better enforcement itself will yield more revenues to the states.

The incremental revenues from taxation of land and liquor will help in keeping the GST rate low. Without it, the revenue neutral rate for the GST is estimated to be in the range of 20 per cent plus. How fair is it to impose such a high burden on the common man while excluding these sectors from the GST ?

The GST will not only bring rich economic benefits, it would make the current tax system cleaner. It will also contribute to cleansing the system of black money.

(This article was covered on Oct 16, 2014 in Business Standard