Opinion | Moving from chaos to order: The overdue step to a simpler GST

The next government should plan to eventually move to a lower standard rate

Most economic policy follows an entropic path. The first iteration is a relatively clean structure that gets complicated either as experience kicks in or interest groups begin to get their way. The Indian tryst with indirect tax reform seems to be moving in the opposite direction—from chaos to order. The initial version of the new goods and services tax (GST) was extremely complicated. There are now welcome moves to simplify it.

This is a good time to reiterate three core economic principles. First, one of the key insights from Adam Smith is that the division of labour is limited by the extent of the market. India now has a truly common market some seven decades after its political integration. The integration of the Indian market as well as the rewiring of supply chains because of GST should lower transaction costs and improve economic efficiency.

Second, the classic papers by Peter Diamond and James Mirrlees on optimal taxation tell us that a good fiscal system should not tax the production of intermediate goods. That is the logic underlying all value-added taxes such as GST, which, in effect, eliminate taxes on production and distribution. The tax is paid on final consumption. It is a destination tax that is collected at the point of consumption.

Third, indirect taxes tend to be regressive in nature. However, the preferred solution should not be a complicated GST structure with many rates, but a low standard or modal rate with a small list of exemptions. A better way to make a tax system more just is by lowering regressive indirect tax rates while widening the base for progressive direct taxes on income and corporate profits. The scope for lowering the GST rate is umbilically linked to direct tax reform.

The complicated GST structure we began with can partly be explained by the messy federal bargaining in the GST Council and partly by a flawed incentive structure. The cost of the policy failure is obvious. GST collections have been weaker than expected while compliance costs for enterprises have increased. Economist Indira Rajaraman has pointed out to two major incentive design flaws during the initial GST negotiations.

The first incentive problem arose because of the political decision that all decisions in the GST Council should be unanimous. There was a valid reason why such a decision had to be taken. The states had just given up most of their taxation powers. Their fears needed to be assuaged. Everybody needed to be on board. However, the unanimity principle also meant that blocking decisions became almost costless for even the smallest state. The bargaining that followed led to a mess.

The second incentive problem was that New Delhi guaranteed the states that their revenues from GST would grow at 14% a year. Any shortfall would be compensated. The fixed guarantee—rather than it being linked to an underlying growth in nominal output—meant that the states went into GST Council meetings with little incentive to select a rate structure that would maximize growth. The insurance policy handed to them gave them little incentive to push for a more sensible GST.

A World Bank study published in May 2018 said that the Indian GST rate was the second highest among the 115 countries with a national value-added tax. It was also the most complicated, with five main tax rates, several exemptions, a cess and a special rate for gold. The multilateral lender said that only five countries had four or more non-zero tax rates—India, Italy, Pakistan, Luxembourg and Ghana.

Forty-nine countries had a single indirect tax rate while 28 had two slabs. The recent rationalization of GST rates and the simplification of some reporting procedures is welcome. What now? Ten years ago, the Thirteenth Finance Commission asked a committee headed by Arbind Modi to make recommendations on the design of the GST. It provided 10 key principles for the design of an efficient GST, such as covering all goods and services, including immovable property, a single low rate, destination-based, zero rate on exports, and threshold exemption for small enterprises.

The Modi committee had recommended a 12% GST rate, of which 5% would go to the Union government, 5% to the state governments and the other 2% to the third tier of government. The final slice was a revolutionary idea that needs constitutional changes or at the very least functioning state finance commissions.

The government now seems to be moving towards an 18% standard rate, much higher than what had been recommended in 2009. The conservatism is perhaps warranted given the subpar GST collections, but the next government should plan to eventually move to a lower standard rate as exemptions are reduced, real estate and petroleum are brought into the GST net, tax compliance improves, and there is more revenue buoyancy.

The tussle over GST design has sometimes been described as a tussle between fiscal economists who want a clean structure that will maximize efficiency and tax administrators who fear revenue losses if the tax rate is unrealistically low. The problems of the complicated GST with high compliance costs are now evident. The next government —of whatever political persuasion—will have the onerous task of untangling the mess.

Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute. Read his previous columns at www.livemint.com/cafeeconomics