The design and alignment of a multiple tax system in large federations such as India is perhaps the most important policy challenge for public finance professionals.
Across three levels of government—Union, state and local, each with definite but overlapping constitutional mandates—economic agents face a myriad of taxes, levies and user fees. Tax regimes that operate at cross-purposes undermine desirable incentive structures and impose added transaction costs on all economic agents. Improving the efficiency of a tax system in a federation can significantly lower the tax burden on all factors of production without the need to lower revenues for the government that rate cuts or tax expenditures almost inevitably imply.
Illustration: Jayachandran / Mint
A unified tax system is also a necessary condition for a common market to exist; this permits free and unimpeded movement of goods and services across a federation, thus encouraging efficient regional specialization. This also enables to accrue to the economy the benefits of increasing returns, particularly in the modern sector of the economy. Finally, tax reforms can significantly lower the costs of doing business; firms can decide on the appropriate level of vertical and horizontal integration based on a business case and not, as is often the case in India, on tax planning. For these reasons, it is worthwhile putting time, effort and resources into improving the design efficiency of the tax system.
For personal and corporate income taxes, there is a close relationship between the federal and provincial systems. In India, these taxes are levied and collected by the Centre and their vertical and horizontal distribution is determined by the Finance Commissions in accordance with our Constitution. The same is also true of taxes on international trade. In the Indian context, there is the greatest dissonance in the realm of taxes on goods and services. I will today argue the case for a “grand bargain” between different units of the Indian federation as well as relevant stakeholders such as businesses, consumers and suppliers of factors of production, to harmonize the system of indirect taxes on goods and services. This harmonization will significantly reduce the vertical imbalance between the Centre and the states by enhancing the tax base of the states. This will also bring very significant macroeconomic benefits. The instrument to secure this is the goods and services tax, or GST, which is proposed to be introduced in India from 1 April 2010.
To my mind, the introduction of GST would be the biggest measure after the elimination of licensing in 1991. In fact, this could also provide the requisite stimulus to the economy during the current economic slowdown.
GST is in essence a simple broad-based form of taxation. Businesses are assessed for taxes on the total value of their sales, but receive credit for the taxes paid by their suppliers. In this way, only the incremental value added at each stage of production is taxed. Consumers pay the tax on final goods and services purchased. In terms of the national economic identity, therefore, a tax is levied on that part of value added which is consumed. Exports are “zero rated”, as in competitive international markets you cannot export taxes.
It is important that we carefully understand the theoretical case for GST. The case is straightforward—income is taxed irrespective of source and use; if consumption is to be taxed, then the same principle should apply. This minimizes the distortions in the economic choices of agents. This is the feasible second best solution, compared with the unattainable first best distortion-free world of lump sum taxation.
An interesting question is, what are the principles that a well designed GST should embody? Prof. Charles MClure identifies six characteristics of a well-designed GST in the federal system. The first two are important for economic reasons, the third for administrative reasons, the fourth for political reasons, and the last two come into play in a system of multi-level finance such as we have in our country. These principles are:
• Uniform rate of taxation within a given jurisdiction, ideally at a single rate
• Sales would be taxed under the destination principle
• Low costs of compliance and administration
• Each level of government to set its own tax rate subject to agreed ceilings and/or floors
• A substantively common tax base for Union and state governments
• Substantial cooperation in tax administration between all levels of government.
In India, in designing GST, we will also need to ensure minimum exemptions, limiting exemptions to goods such as essential food and medicines.
With the above principles in place, a flawless GST emerges as a hugely attractive policy option in the Indian context. The present economic crisis portends a huge challenge; the only “gain without pain” will come if we can improve the efficiency of the economy and, thereby, our productivity and international competitiveness. In an open economy, international competitiveness implies improving the efficiency of our domestic industry vis-à-vis imports and of our exports vis-à-vis our competitors, and this GST will help our economy to achieve.
One of the most important factors adversely affecting our competitiveness is the current indirect tax system. High import tariffs, excises and turnover tax on domestic goods and services have enormous cascading effects, leading to a distorted structure of production, consumption and exports. The existing tax system introduces myriad distortions that favour some goods and services at the expense of others. The manufacturing sector, thanks to the levels and cascading of indirect taxes, is so highly taxed that India is an outlier in terms of taxation. Conversely, services tend to be significantly under-taxed. These distortions yield inefficient resource allocation, and come at the price of inferior GDP growth. This is an important reason why the share of the manufacturing sector in the total GDP in India is one of the lowest among all dynamic emerging market economies. Such distortions also affect in achieving an acceleration in the growth of manufacturers, particularly labour-intensive manufacturers, which is so needed to meet the coming challenge of providing productive employment at growing numbers.
A well-designed destination-based GST on all goods and services is the most elegant method of eliminating distortions and taxing consumption. Under this structure, the different stages of production and distribution can be interpreted as a mere tax pass-through, and the tax essentially “sticks” on final consumption within the taxing jurisdiction.
Introducing GST will do more than simply redistribute the tax burden from one sector or group to another. The introduction of GST yields a macroeconomic dividend as it reduces the overall incidence of indirect taxation, and therefore the overall tax burden, by removing the many distortionary features of the current sales tax system. There are four important macroeconomic channels through which this happens:
• The failure to tax all goods and services distorts consumption decisions; it weakens the signalling power of relative prices. GST reduces these distortions and enables economic agents to respond more effectively to price signals
• The unrefunded taxation of capital goods discourages savings and investment and retards productivity growth. This is perhaps the most important gain through the introduction of GST in an economy such as India
• For a given constellation of exchange rates and price levels, violation of the destination principle places local producers at a competitive disadvantage, relative to those in other jurisdictions
• Differences in tax bases of different states and the Union government greatly increase costs of doing business. GST-based tax reform provides a policy opportunity to do something about this problem without waiting for prior and sweeping political economy changes.
This is a cutting edge policy issue in the current economic context of India. The Report of the Task Force on Implementation of the Fiscal Responsibility and Budget Management Act, 2003 recommended the introduction of a comprehensive dual goods and services tax to be levied on a common base by both the Centre and the states. This levy was intended to subsume all indirect taxes levied by both. The macroeconomic gains from this reform were to provide the wherewithal for the “grand bargain”. This recommendation was accepted by the government and Union Budget 2006 stipulated that the government will collaborate with the states to introduce a comprehensive GST on 1 April 2010. The empowered committee of the state finance ministers has since then made considerable progress on finalizing the design of GST. The government has also agreed in principle to the design. The 13th Finance Commission is charged with assessing the impact of GST on the fiscal position of all units of the federation, including the impact on foreign trade. It is already clear that a well-designed revenue-neutral GST will enhance the revenue buoyancy of the states in future. This will also be a major structural correction in our country’s intergovernmental revenue assignments, thereby reducing vertical imbalance between the Centre and the states. In the coming months, they will finalize the design of GST. I hope they will ensure—
• Minimum number of rates and exemptions so as to achieve widest possible tax base
• Removal of distorting state taxes such as entry tax, octroi and high stamp duties by subsuming them in GST.
This will help to achieve reasonably low GST rates ensuring nationwide acceptability, high compliance and revenue gains to all members of the federation.
From a policymaker’s perspective, the macroeconomic benefits of GST are clear. GST will create a common market across the length and breadth of the country, something which has eluded us for long. There will also be a reduction in the overall tax burden. At present, the combined statutory rate of VAT is close to 30%. This marginal rate is applied to a narrow base. As a result, the effective rate is extremely low. Since economic decisions and compliance behaviour are based on the marginal rate, the higher the rate, the greater the distortion and evasion. Our preliminary research indicates that the effective revenue-neutral rate at which GST can be implemented will be far lower than 30%, indicating a significant reduction in the effective tax burden on our economic agents. Consequent to alignment with the lower effective rate, we can also expect an upsurge in compliance as has been witnessed in the case of direct taxes.
Considering the high level of distortions extant in the Indian indirect tax system, one can argue that in India, the real output effect of a well-designed and properly implemented GST would be at least 1.4% of the GDP that was found in Canada; this is $15 billion annually, implying that the economic value of these GST reforms would, at a modest 3% discount rate, be close to $500 billion or 50% of the country’s present GDP. More importantly, this means potentially creating an additional productive employment of as much as four-five million. There are indeed spectacular returns from a policy reform.
Vijay Kelkar is chairman, 13th Finance Commission. These are edited excerpts from his convocation address at the Indira Gandhi Institute of Development Research, Mumbai. Comments are welcome at firstname.lastname@example.org