It would be apparent to even a casual observer of India?s political economy over the last two decades how difficult it is for the political process to implement the agenda of economic reform. The power of vested interests is strong and a majority of politicians across the ideological spectrum still remain unconvinced about the need to keep up to speed with reform.
That leaves reforming politicians limited room for manoeuvre. And they must choose wisely before spending precious political capital to get things done. It makes eminent sense, therefore, to line up behind those reforms that truly have a game-changing potential for the economy. The overhaul of India?s archaic indirect tax system (rendered terribly inefficient by multiple and cascading taxes) and its replacement with a new goods and services tax (GST) is one such game-changing item.
Interestingly enough, unlike many other big ticket reform ideas, the introduction of GST is not likely to evoke much populist protest or popular unrest on the streets. It isn?t like the decontrol of fuel prices that prompted a debilitating nationwide bandh. It isn?t even like discussing FDI in retail, something that evokes howls of populist protest on behalf of the kirana store owners. On the contrary, if implemented at a uniform and reasonable rate, it should gather widespread popular support for easing the tax burden on the aam aadmi and aam business.
That is why its is disappointing to watch the Centre succumb to the narrow interests that are blocking the rollout of a perfect GST. It seems that state finance ministers who have consistently objected to the very sensible recommendations of the 13th Finance Commission on GST have finally won their battle against the Centre. Finance minister Pranab Mukherjee has conceded ground on three crucial principles that should never have been up for negotiation. First, the need to have one rate. Under the compromise there will be three, one for goods, one for services and one for essential goods. There will now be lobbying and rent-seeking to get goods included in the essential list that are taxed at a much lower rate. Second, the need to do away with all exemptions, which if present, would only encourage lobbying and rent-seeking from those seeking further exemptions. Under the compromise offered by the FM, 99 items will be exempt from GST. And third, the need to have a reasonably low rate in order to increase compliance. The finance commission had recommended a revenue-neutral rate of 12%. The FM has promised a final rate of 16%, to be converged on in three years time.
Principles aside, there lies a great risk at the point of rollout. In the first year of implementation, the FM proposes to levy GST at 20% on goods (10% for Centre and 10% for states). Unfortunately, this isn?t much lower than the total incidence (around 25%) of the complicated indirect tax system we have at present. So, the GST will get a bad advertisement in its very first year. What is worse, the 20% rate may encourage people to continue evading indirect taxes just like they do under the current system. If that were to happen, the game-changing potential of the GST may be lost in its very first year, never mind if the rate comes down a couple of percentage points a year later.
There may be yet another problem. If compliance does not increase substantially, there is every chance that neither the Centre nor the states will see a sudden buoyancy in revenues. That will make the states, in particular, very reluctant to consider cuts in the GST rate. The FM may not even be able to convince the states to move down to his 16% target rate within three years. In India, path dependency is strong and if the GST gets off to a bad start with the aam aadmi, aam business and governments, its entire purpose could be defeated very soon.
It would have been so much more appropriate for the finance minister to have insisted on a 12% rate, and given a more generous 7% of that to states. Incidentally, that is the rate now prescribed for essential goods. The states would have had only one legitimate reason to protest?potential revenue loss. For this, the FM should have thrown his grand bargain on the table offering to compensate states for losses. Incredibly, he has handed out this carrot even while compromising on key principles.
If any further compromise was required, the Centre could have left open the option to raise the 12% rate sometime in the future, should revenue targets have fallen short?according to all the studies available it would not fall short at this rate. Still, the offer to raise rates in the future from a low base would have been a better path to compromise than setting the rate high initially and then bringing it down?something that is likely to be constrained by path dependency.
But it seems, after all, that pressure from 25-odd state finance ministers was too much to bear for the wily veteran, Pranab Mukherjee.
?dhiraj.nayyar@expressindia.com