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Business News/ Opinion / Constitution bill sows seeds of fractious federalism
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Constitution bill sows seeds of fractious federalism

The 100% revenue compensation guarantee for extended period of time creates a moral hazard of demotivating the states from improving the tax system and administration

A file photo of finance minister Arun Jaitley. Photo: MintPremium
A file photo of finance minister Arun Jaitley. Photo: Mint

The goods and services tax (GST) constitution bill (122nd Constitution Amendment Bill, 2014) tabled by finance minister Arun Jaitley in December is a victory for the states. But sown in the victory are the seeds of fractious federalism.

The states, including Gujarat and Maharashtra, formed a unanimous front and refused to budge even an inch in their negotiations with the Centre. The more the discussions were prolonged, the more the states added to their demands. To break the impasse, the Centre had to concede to all of their demands and go beyond.

The resistance of the states would be understandable if their demands made economic sense or contributed to a better tax design. But they neither serve the interests of the economy, nor of the tax system.

Consider, for example, their demand for exemption of land and alcohol. The states have defended this demand to protect revenues from these products. This is baseless. Extension of tax to these products does not lead to any revenue loss. To the contrary, it strengthens the revenue base, makes evasion more difficult and simplifies compliance.

The only revenues at risk are private profits of non-compliant taxpayers, who collude with authorities and thrive on the opaqueness of the current system. Catering to the interests of the dishonest in the Constitution of this land of Bharat, which is built on the foundation of truth and peace, would be an act of sacrilege.

The GST model enshrined in the bill envisions a substantial degree of cooperation among the states and the Centre for the noble cause of a better indirect tax system—one that is fully harmonised in design, replaces all the existing domestic indirect taxes, and is administered through a fully automated platform with minimal human interface. It is also one that facilitates free movement of goods and services across the common market of India.

The demands of the states suggest they are not wedded to these goals. If so, their cooperation would be lacking, making the GST council debates fractious.

The areas of disagreement would be several. The first would be the compensation for revenue loss to the states. The states’ fears of revenue loss are baseless and the demands of compensation from the Centre questionable. Internationally, a properly-designed GST has proven to be a cash cow, leading to a significant revenue gain, not a loss. The gain comes from broadening the tax base, improved compliance from lower tax rates and an enlarged gross domestic product (GDP) pie through boost to investment and economic growth.

In New Zealand, the GST reform in 1987 yielded a fiscal dividend of 40% plus in the very first year of its implementation. The states in India also experienced a significant revenue gain from the adoption of value-added tax (VAT) in 2005.

If for any reason, revenues turn out to be lower than projected, the logical thing would be to adjust the tax base and rates suitably to close the gap and not demand compensation from the Centre.

If states lose revenue, presumably so will the Centre, given the common GST design for both. Why should then one government compensate the other, except as a transition relief pending adjustment of the tax base and rates?

The 100% revenue compensation guarantee for extended period of time creates a moral hazard of demotivating the states from improving the tax system and administration. The compensation will act like a 100% penalty on any improvement in revenue collection by the states.

The determination of the revenue loss to be compensated would itself be a source of friction. The states would demand that they be compensated for any shortfall from the trend growth in revenues in the past. This demand would be contentious.

The buoyancy of the current VAT system has come down in the recent period, in part due to the lower economic growth, and could come down further because of the decline in oil prices and inflation.

The wholesale price index (WPI) has already come down to virtually zero, which would translate into much lower growth in VAT revenue. Thus, the assumption of continuation of the trend growth in revenues would be wrong, and become a point of friction in the GST council.

The second point of friction would be the GST’s design itself. The design that has been developed by the empowered committee is flawed. Its base is narrow—as little as 50% of the comprehensive base.

As a result, the revenue neutral rate has been pushed up to the stratosphere at an unrealistically high range of 27%. This system would not be conducive to voluntary compliance and will lead to classification disputes and lower economic growth.

Exclusion of petroleum, liquor, real estate and even electricity would be another point of friction. There is no economic, social or tax policy justification for these exclusions. States would deny any credit for taxes on production inputs to these sectors, which would lead to cascading and lower investment in the sectors.

If the buoyancy of government revenues comes down because of lower inflation and lower prices of petroleum, states’ penchant for retrograde changes in tax design to protect their revenues would make the GST council a battleground between the rational and the irrational.

States would resort to measures such as blockage of input tax credits and delay or denial of export refunds, which would convert GST into a third-rate reform for the second-rate status quo.

Yet another point of contention would be the insistence of the producing states (Gujarat, Maharashtra, Haryana and Punjab) to continue the 1% additional tax on inter-state sales beyond two years. The tax will bite harder than the current 2% central sales tax as it will apply to both inter-state sales and branch transfers. This tax is contrary to the destination principle of GST and leads to tax cascading (being not creditable), and will substantially negate the benefits of GST.

The states have acted like a fractious nobility in their GST deliberations. Nobility is defined as the noble class, a hereditary group of landowners who usually have legal privileges and political powers that sets them apart. Fractious means that they are not a unified nor cooperative group; they have interests of their own that tend to pit them against both the king and each other, making it difficult for the king to get anything done.

Will this nobility “tango" with the Centre? If not, the country will pay the price for their “tangle".

Given the risks of stalemate under such a system, it might be advisable to send the bill to the parliamentary standing committee to put it back on track to the destination of the game-changer GST.

Satya Poddar is tax partner, policy advisory group, at EY.

(Views expressed are personal)

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Updated: 23 Feb 2015, 12:55 AM IST
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