GST: Far-reaching reform; major adjustment costs

The shift to a single, integrated goods and services tax is a structural reform that probably eclipses every other since 1991 for its economic and political significance


Photo: Hindustan Times
Photo: Hindustan Times

Last week’s Constitutional amendment to allow the shift to a single, integrated goods and services tax (GST) is a structural reform that probably eclipses every other since 1991 for its economic and political significance. There are enough reasons to temper expectations from a change that, in magnitude, will hugely reorganize established federal relations. On its way and across the political-economic space, it will also encounter the country’s well-known but not-so-well understood rigidities. The many complex and heterogeneous issues ranging from pricing behaviour to execution capacities and abilities, compliances and administrative efficiencies, to name but a few, also will come in the way. These collective adjustment costs will weigh in on India’s transition from a fragmented indirect tax system to a uniform one—a reform that is welcome for its indisputable improvements to the hotchpotch network of taxes across the country.

Many analysts and observers have commented upon this forthcoming change, its foreseeable evolution and impact. As of now, the expected gains from replacing numerous indirect taxes at central (excise and customs duties, service tax) and state (VAT/sales, purchase, entertainment, luxury and entry taxes, octroi, etc.) levels are, inter alia, lower prices and transportation costs; improved efficiency and compliance, lower administration costs, a wider base and more tax revenues. As a result, productivity is to get a boost, with a 1.5-2 percentage point addition to gross domestic product as per some estimates.

Three features about India merit noting in this context.

The first is the setting of fiscal policy, the Union’s responsibility for the whole economy. Considerations of this duty will weigh against the states’ concerns, i.e. respective revenue-debt positions, at the GST council (consisting of central and state finance ministers), which will now decide tax rates and all such. Recall the speedy government response to the 2008 global financial crisis—an across-the-board, 4 percentage point cut in central excise duty and an associated revenue loss of about Rs.8700 crores? Now, fine-tuning indirect taxes to aggregate demand variations will be more of a federal-consensus decision. Macroeconomic concerns may or may not coincide with what could be pressing issues for states, whose association with macro policies has so far been confined to acceptance of the deficit limits they can run. There are very challenging, difficult political adjustments here.

The second point is about product price movements following the removal of the cascading effects of taxes that GST will replace along the manufacturer-wholesaler-retail line. Price changes could also originate from re-categorisation under different slab rates. In practice though, it is the pricing behaviour of agents, i.e. producers, wholesalers and retailers, that will determine if prices lower or not. Will cost reductions be passed on fully or even partly? The downward rigidities to nominal prices will no doubt play a role here, preventing full, or even partial pass through of cost reductions to the consumer.

Finally, when all look ahead to more taxpayers and revenues, India’s tax-reform history shows that three major reforms since 1991—folding services into taxation (1994-95; subsequent rising coverage and tax rates), value-added tax (VAT) replacing a sales tax system (April 1, 2005; different states adopted it at various points), and many incremental changes in administration structures and practices to secure potential tax revenues—haven’t sustainably lifted the tax-GDP ratio (15-17%), whose trend average continues at 15%. India remains a laggard in international comparison, including emerging market peers. Total tax-GDP ratio is about 10 percentage points lower than the OECD average (25%). China’s tax-GDP ratio was par with India at 16% in 2009 but it has now gone past 19%. Past reforms have not optimally exploited efficiency gains and failed to consolidate into permanent gains. This should reckon in the implementation, if not expectations.

Renu Kohli is a New Delhi-based economist.

READ MORE