India’s rational tax system

Dated 8th February, 2016

Introduction of Goods and Services Tax (GST) will be a crucial step towards tax reforms in India. Abolishing several central and state taxes and replacing them by one single tax will mitigate the recurring problem of double taxation and for the first time, create a common national market. Due to the federal nature of the Indian polity, GST will be simultaneously implemented by the states and the Centre.  The Constitution clearly demarcates the taxation power between the Centre and states. Any new system of taxation, like the GST where both the Centre and states conform to certain common principles, thereby giving up their taxation rights, must be assessed against the principle of economic efficiency and the advantages that will accrue to states, the Centre and citizens by establishing a common national market.

GST will benefit the state and central governments as it simplifies the tax system, broadens the tax base, holds the promise of improving tax compliance and revenue collections and efficiently uses the administrative resources. Industry will derive several benefits from the GST. Some of the important advantages are low compliance cost for companies, simplified business processes, means of exemption instead of exclusion under the GST, and most importantly, no requirement of verification on the inter-state movements of goods and services.

Some of the prominent features of GST are:  it follows a destination--based taxation pattern and is applicable to all stages of the value chain, rather than being used to mark and tax goods at every stage of production; GST will be applied to taxable supplies of goods and services.  Thus all goods and services are likely to be covered by GST except, alcohol, electricity duty, real estate related taxes and petroleum products.  Once the GST is implemented, main central taxes that will be removed are central excise duty, service tax, surcharges and additional excise duties. Some of the important state taxes that will be removed are state Value Added Tax (VAT)/ sales tax, central sales tax which at present is levied by the Centre but collected by the state, purchase tax, luxury tax and entertainment tax.

The pending GST bill provides for the levy of Integrated GST on inter-state transactions by giving/conferring powers to both the states and the Centre.  Despite the improvements, which have been made over the past few years in terms of tax design and administrative costs, the tax system at both central and state levels remains cumbersome and complicated. Due to its needless complexity it makes many business transactions subject to disputes and court challenges. The process for dispute resolution is often slow and expensive and this makes the present tax regime inefficient as it diligently suffers from substantial compliance costs, leaving aside the exception of highly organized sector.

The Empowered Committee of the State Finance Ministers described the GST bill as  ‘a further significant improvement towards a comprehensive tax reform in the country’. Thus GST has a potential to be the most important initiative in the fiscal history of India.  Once passed and implemented it can pave the way for modernization and reform of the present tax administration and increase voluntary tax compliance. The current taxation system  creates a big burden on businesses that sell across state borders. This is the reason, in part, why India’s manufacturing sector contributes a relatively smaller share to its GDP when compared to other emerging economies.

Thus lamentably, India does not even have a free trade agreement with itself; let alone with countries across its borders. Apart from the lack of domestic free market, the division of fiscal powers between the Centre and the states has created a situation where the Centre taxes a commodity during production, wherein the State at the point of consumption. This arrangement gives rise to what is called “tax on tax”, where the Centre taxes goods when they are ready to leave the factory, and the states target them at sale.

At the time of introduction of the VAT regime, it was recognized to be the only feasible option within the prevalent framework of taxation, with promise of creating a more rational tax system in the future. In 2005, when VAT was introduced replacing the state taxes, it was considered to be a radical step forward in the reform of domestic trade taxes in India. The new GST will change the tax system and resolve the problem of dual taxation, where taxes are imposed by the union and states separately. GST will unify taxes under one umbrella. Financial experts argue that the GST will help the economy become more efficient by improving the tax collection, dismantling tax barriers between states, and integrating the whole market by a single tax rate.

At present VAT is the highest contributor to tax revenues of state governments. With the introduction of GST, states are worried that it may curb their revenue generation capacities. To neutralize any expected revenue losses state governments are demanding compensation from the Centre. However, states’ revenue concerns can be addressed partially through suitable tax administrative designs and cooperative   agreements between the Centre and the states.

With liberalisation of the Indian economy, consumption and production of goods and services is undoubtedly increasing, and because of multiplicity of taxes in the current tax regime, administrative and compliance costs are being added on to the bandwagon of tax complications.  There is a strong consensus amongst financial experts that GST will create a coherent and simplified tax system. In the long-term it should lead to higher financial output, better employment opportunities, and therefore increase India’s GDP by 1-1.5 per cent. There is hardly any skepticism in economic/fiscal policy circles regarding GST’s efficacy and that it will give India at long last, a rational tax system. Although the way it really performs and its effectiveness would be bound by state-centre coordination and timely implementation.

Introducing GST is akin to making a fundamental reform on how the Indian market would work and opportunities for growth the Indian entrepreneur will have in the coming decades. Opportunity for a useful reform is hard to come by; the NDA government should not lose this precious opportunity in (national) party-politics. Economic growth is beyond the purview of any political party and is more in the realm of political economics.

There is a substantial consensus with regard to GST; thus in the prevalent economic conditions missing out on the opportunity of creating a united and pan-India market would be detrimental to the needs of the economy and the entrepreneur.