Home / Budget 2019 / Opinion /  Opinion | Sitharaman should fix the tax system to boost confidence

Finance minister Nirmala Sitharaman will present her second Union budget on 1 February. Sitharaman is likely to tell Parliament that the government has missed the fiscal deficit target set for the current financial year. Fiscal expansion should not be a worry when nominal economic growth has collapsed. That is exactly how automatic fiscal stabilizers operate. Tax collections weaken and social spending increases during economic downturns. The higher fiscal deficit supports aggregate demand till private sector demand gets back on track, and tax collections recover.

This column had previously argued that market fears about fiscal profligacy would need to be assuaged in three ways. The government would first have to announce credible budgetary estimates compared to what happened last year. It would also have to provide a fiscal consolidation roadmap for the medium term. The government would also have to push ahead with policy announcements that boost business confidence. A commitment to fix the tax system would be a good starting point.

Meanwhile, neighbouring Bhutan has this month overhauled its indirect tax system. Its government announced that it is replacing 11 rates of excise duties with a flat 7% goods and services tax (GST). There will be a single tax rate on all economic transactions other than a handful of products such as alcohol, tobacco and plastic wrapping. The experience of the small Himalayan kingdom is obviously a poor way to judge the GST structure in a complex federal democracy such as India, but it is useful to anyway remember that India has one of the most complex GST structures in the world, one that almost defeats the purpose of the national value added tax.

The World Bank said in March 2018 that 49 countries have a single-rate GST, 28 countries have two rates, and only five countries have four rates other than zero. These countries are Italy, Luxembourg, Ghana, Pakistan and India. Such a GST tangle can partly be explained by the complex federal bargaining that preceded the launch of the new tax, and the principle of unanimity during these negotiations ensured that every state had the power to hold out till it got its way. The underlying analytical error is to look at the progressivity of every single tax in isolation, rather than of the fiscal system as a whole. What matters is the latter. Too many commentators missed this rather simple principle of public economics when they were batting for a complex GST.

The GST Council has thankfully been in corrective mode since the middle of 2018. The tax rates on literally hundreds of economic transactions have been changed. However, the rather haphazard rationalization of the GST structure has led to three significant problems.

First, the high frequency of tax changes has meant that the system is not stable. Businessmen will never be sure what the next meeting of the GST Council will unleash. What is needed is a proper roadmap to transition to a more efficient GST, similar to the carefully thought out Indian trade reforms of the 1990s that brought tax rates down to East Asian levels.

Second, the multiplicity of tax changes has reportedly led to cases of an inverted tax structure, where the tax on inputs has been higher than the tax on the final consumer good. Companies have accumulated tax credits as a result of this, or in effect will get back more than the tax they pay, a fact that even the GST Council has recognized. The goal should be to have a single GST rate, with very few exemptions and a punitive tax rate on a few sin goods. One immediate solution, as Arvind Virmani has suggested, is that the GST rate on all capital and intermediate goods should be made 12%.

Third, the erratic GST cuts have in effect brought the tax rate below what the finance ministry had accepted as the revenue neutral rate. Economists at the Reserve Bank of India have estimated in a September 2019 paper that the rationalization of tax rates by the GST Council has brought down the effective weighted average GST rate from 14.4%, when the new tax was introduced, to 11.6% when the study was done. This requires more careful study by fiscal economists at a time when the Indian economy has lost momentum.

Finally, the core economic case for the GST is still worth reiterating. First, economists since Adam Smith have said that productivity growth through the division of labour is limited by the size of the market. GST integrates India into a single economic unit that will improve economic efficiency, especially through the rewiring of corporate supply chains.

Second, Nobel laureates Peter Diamond and James Mirrlees have shown in two classic papers on optimal taxation that a good fiscal system should tax income and consumption rather than the production of intermediate goods. That will maximize economic efficiency. The GST is actually a tax on final consumption rather than a tax paid across the value chain, and is thus close to the Diamond-Mirrlees norm.

There is finally a broad consensus that GST version 1.0 is suboptimal. The finance minister will hopefully begin the journey towards GST 2.0.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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