The debate over the goods and services tax (GST) conflates two objectives. Firstly, rationalizing and merging various indirect taxes to have internal borderless travel of goods and services so that better economies of scale can be realized. And secondly, to then have a uniform tax rate in all the states—which is ostensibly crucial to integrate the market.
But an integrated market—with no border delays and octroi—can be fully achieved with better use of information technology and better state-Centre coordination, and does not require a uniform tax rate in all the states. For example, the European Union has achieved a single, efficient market while still having different value-added tax (VAT) rates for its member states using the VAT Information Exchange System. India’s Tax Information Exchange System can be used similarly.
The dual-structure GST proposal (instead of a single national GST rate) pays lip service to fiscal federalism. It would entail a Central GST rate and a separate GST rate for the states (but not different among the states). Now this plan may have some administrative advantages but, fundamentally, a single GST and a dual but uniform GST are the same as far as tax incidence and incentives are concerned.
Instead, we should have a Central GST and a state GST—with the states free to have different rates on the latter so that we can preserve and enhance inter-state fiscal competition. This is because if state leaders cannot politically benefit from cutting taxes, then why will they forgo the political benefits of increased spending? State politicians would then present the Centre with the fait accompli of huge budget deficits. When this is replicated throughout the country, a uniform GST rate would have to be increased again and again, greatly harming the economy.
But some sceptics of tax competition say a “race to the bottom” could take place, with states drastically cutting spending to cut taxes. This makes as much sense as saying that a price war in the electronics market would destroy quality. Taxpayers, like consumers, operate on two variables—cost and quality. Tax competition makes state spending more efficient and does not necessarily decrease it: A state could choose to have great infrastructure and social insurance, and firms might be ready to pay higher taxes to locate there. Such policy experimentation in the states—the “laboratories of democracy”—is useful because the successful policies are then copied by other states.
Yet fiscal federalism can also mean state-level crony capitalism, which escapes the notice of the national media. But by having a common tax base throughout the country, state politicians would not be able to offer arbitrary tax breaks. Now, some might ask, how is having a uniform rate anti-federalism, but a common base not so? This is because federalism means allowing maximum flexibility in the policy of states so far as the rule of law is not violated—that is, any policy can be followed, so long as specific individuals or companies are not unduly privileged or discriminated against.
Accountability and efficiency are best served when the expenditure and income are done at the same administrative levels unless there are significant spillover effects. And for equity reasons, the Centre can always spend more on the backward states from its revenue share (and if the Central welfare schemes are means-tested, that will happen automatically anyway).
We need to learn from the European, American and Canadian models to figure out how to have an integrated market while still having separate tax rates within. A few countries such as Australia have gone for uniform rates—but a huge economy and heterogeneous polity like India’s needs to be aware of the dangers of fiscal centralization.
Harsh Gupta writes for Pragati—The Indian National Interest Review. Comment at firstname.lastname@example.org