Over the last few days, there have been extensive discussions on the prospects of reforming India’s Goods and Services Tax (GST). An important element of the proposed reform is to reduce the present 4-rate structure to a 3-rate one.
There could be several objectives behind such a reform. Simplification of the tax structure is an obvious one. Revenue mobilisation could be another, as simpler tax structures are easy to administer and improve compliance. The third is to provide a stimulus to the economy, which is presently dealing with significant uncertainty.
I am young enough to be excited by the prospects of tax reforms, but old enough to know better. More so, given my prior experience in trying to understand the GST.
Complex Nature of GST
Popular perception suggests there are just four GST tax slabs: 5, 12, 18, and 28 per cent. Why so many slabs for an indirect tax? Because somehow Indian policymaking believes in the progressivity of taxes—even for consumption goods. A lesser-known reality of the GST is that it has a total of eight tax slabs, excluding the exemptions. These start at 0.25 and go all the way up to 28 per cent. Tax rates of 0.25, 1.5, 3 and 7.5 per cent apply to just 1.5 per cent of total goods traded in India. Some sectors, such as construction services, have six different applicable tax rates ranging from 0 to 18 per cent. The sheer complexity of India’s present GST, even after nine years of existence, should be reason enough for an urgent reform.
A major issue with the GST’s present structure is the pervasive use of end-use exemptions. That is, for certain items, a GST rate is applicable – but if the good is used for a specific purpose, then there is no GST on the item. Therefore, the same item has two different tax slabs depending on the buyer and end-use of the item. Moreover, it creates room for rent-seeking, as many would exploit the tax arbitrage introduced by having a 0 per cent and 18 per cent tax rate as applicable on the same good. Administering such exemptions is excessively costly and goes against the spirit of a self-enforcing tax such as the GST.
A comprehensive reform would do away with such end-use exemptions and identify a specific list of items, such as food – irrespective of whether packaged, processed, or prepared in a restaurant – to be classified as exempt. Similar exemptions could be extended to certain kinds of insurance.
Ideal rate structure
A single or two-rate structure is very appealing, but in a joint paper, Dr Arvind Virmani and I show that most countries have settled on a three-rate structure. Eliminating end-use exemptions will certainly reduce complexity, but it cannot be achieved without a proper overhaul of the tax structure. We proposed a transition to a 5-15-25 tax structure. In addition, we proposed retaining some exemptions, such as those for food items, but eliminating all other end-use exemptions. Doing so would mean that each item would have only one applicable GST rate, thereby removing any tax arbitrage opportunities.
Most products were proposed to have a tax rate of 15 per cent. The more ambitious reform would place roughly 78 per cent of all items in the 15 per cent tax slab, 6 per cent items at 5 per cent and 3 per cent items in the 25 per cent tax slab. The idea was to put in a system where the majority of products face a uniform GST rate and one that allowed MSMEs to simply use Microsoft Excel or any other simple software to meet their invoicing and tax-compliance requirements.
Media reports suggest an alternate approach has been adopted by the government, whereby the 12 per cent slab has been removed. This would be similar to having a 5-18-40 percent tax structure. India currently enjoys one of the highest peak consumption tax rates at 28 per cent. To increase it further to 40 per cent is excessive and would create a large gap between the 18 per cent and the 40 per cent slab. If the objective is to penalise consumption of sin products such as cigarettes, rather than have a peak tax slab of 40 per cent, government can keep the peak rate at 25 per cent and levy an additional tax on top of this. A peak consumption tax rate of 40 per cent will incentivise businesses to push for lower rates for their products, and it can ultimately create more tax slabs between 18 to 40 per cent.
It is also important to recognise that a major reason – perhaps the only reason why such a reform is being planned is to provide the Indian economy with a stimulus. The objective is to cut taxes and help consumers spend to make up for the weakness in export demands before the festive season kicks in. In our paper, we illustrated that the proposed 5-15-25 tax structure is revenue-neutral. That is, it made sure that the treasury did not lose any money as the effective tax rate was reasonably close to the present rates. In that regard, the 5-18-40 tax structure could end up increasing tax revenues. This goes against the spirit of providing a stimulus to the economy and will be counterproductive, especially at a time when the economy is expecting major external headwinds.
Also read: How GST changed import duty revenue for states—no blame, more profit
Compliance burden
A major issue, and one that is not discussed at length, is the input tax credit. Suppose I buy new shoes to sell in my store. I pay GST to the manufacturer and see my input tax credit in the system. When I sell the shoes, I collect the GST and must hand it to the government. But I can’t claim my input credit unless the manufacturer paid those to the government. In other words, I am now responsible for my vendor’s compliance—and penalised if they don’t comply. Granted that this was introduced in an effort to improve compliance, but it has several unintended consequences, such as choking of working capital and adding to the overall compliance burden.
Simplification of the tax structure is just one part of the story. The other equally important part is to recognise the need for simplification of filing procedures and compliance burden. Here’s hoping that the reform of the GST would be an ambitious one.
Karan Bhasin is a New York-based economist. He tweets @karanbhasin95. Views are personal.
(Edited by Ratan Priya)
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