Indirect tax reforms: A job half done; GST underperforms for its faulty design, rate hike agenda regressive

Taxes continue to get paid on taxes. Economic travails have since forced the policymakers’ hands and deprived them of any headroom for course correction.

GST five years
Economic travails have since forced the policymakers' hands and deprived them of any headroom for course correction.

As India’s goods and services tax (GST) completes five years on June 30, it has, at best, just begun to exhibit flashes of innate brilliance. Revenues have been very buoyant in recent months, so the Centre now expects receipts from this main indirect tax in the current financial year to be a fifth higher than the Budget Estimate (BE) announced in February. In the last financial year, the collections grew a robust 30.5%, albeit on a contracted base (-7%).

GST, however, produced sub-optimal outcome over the half-decade, primarily because of its serious design flaws and policy ad-hocism. The period nevertheless bore testimony to the fact that even an imperfect GST can be decidedly superior to the system of assorted indirect taxes with wider cascade effect it replaced.

As a destination-based consumption tax, GST was to bring about additional revenue productivity and significant “output effect” as taxing gets confined to only the value added at each stage and B2B transactions assume a virtual pass-through status. These gains were hard to detect, at least until lately (GST revenue to GDP ratio was around 6.3% in both FY19 and FY22).

There is no cogent evidence either of a big reduction in the tax incidence on capital investments and production inputs giving a leg up to the economy, though this, too, was one of the promises.

Meanwhile, since the pandemic distorted the economic landscape, opposing views on GST’s efficacy have remained just that: views.

To be fair, it was an arduous task for the then finance minister Arun Jaitley to strike a deal on GST’s structure with state governments after driving a grand bargain. Implicit in that agreement and the laws that soon ensued were major changes in the way administrative powers and revenues are shared between the Centre and the states and states inter se.

What was best possible was done, and it was epochal in itself. All major elements of indirect taxes levied by the Centre and states, except the basic customs duty (import tariff), collapsed into the new tax. But large chunks of economic transactions were kept outside its purview, most notably of auto fuels, natural gas, land, real estate (construction for factory and civil work), alcohol and electricity. As a result, sections of industry including steel, cement and transportation are unable to get full credit of input taxes paid while meeting their output tax liabilities.

Taxes continue to get paid on taxes. Economic travails have since forced the policymakers’ hands and deprived them of any headroom for course correction.

So, as the GST Council holds its 47th meeting in Chandigarh tomorrow, its main agenda will include a review of the GST rates structure, with an intent to align the rates with the so-called revenue-neutral rate (RNR) of about 15% estimated prior to the tax’s launch. There is no immediate plan to extend the tax to the vast areas left out, as both the Centre and states would want to preserve their discretion on the high-revenue-yielding auto fuel taxes and avoid any uncertainties on this front. A series of rate cuts – mainly from the highest slab of 28% – and expansion of the exemption list has admittedly increased the differential between RNR and the weighted average GST rate (11.8% now) by three percentage points.

The council is, however, likely to defer a major overhaul of the GST rates, which may include more rate hikes than cuts and a reduction in the number of slabs to 2 from broadly 4 now, to a future date, because the current high-inflation situation doesn’t allow big tax increases. State governments are demanding that the cushy revenue protection given to them for the last five years be extended. Though only Opposition-ruled states make the demand publicly, other states, restrained for political reasons, would also like an extended compensation period, for sure. Some of the states are also vocal against the tax itself and feel they would have been better off outside it, though facts don’t support this stance.

If the GST had yielded the desired outcomes, the council’s agenda would not have been rate hikes and extended revenue protection for states, but to give more tax reliefs to consumers from a position of revenue strength. As such, high tax rates are antithetical to the concept of a pure value added tax with a large, near-comprehensive base, which the GST is supposed to be.

Countries, which have implemented GST/VAT systems successfully, proved broad tax bases and benign rates result in higher buoyancy. The key to boosting revenue is not higher rates and loading more taxes onto a narrow universe of products and services (transactions), but a broadening of the base which will reduce cascading to the bare minimum.

GST systems similar to India’s in Japan, Austria, Canada, South Africa and New Zealand are marked for much lower rates. These countries saw sudden surges in tax collections post the introduction of GST/VAT, enabling them to slash rates progressively. Some like New Zealand brought the rates down to even below the RNR computed initially. In India, a reasonable growth in revenue was witnessed immediately after GST’s July 2017 launch. Receipts in FY19 were up 9% over FY18 base while state VAT revenues excluding fuel taxes grew just 8.4% in FY17, on a very favourable base.

In the first place, the guaranteed revenue offered to the states (14% annual growth over FY16 level) far exceeded historical trend. GST receipts grew at average annual rate of 9.2% in F19-FY22. As compared to this, states’ VAT receipts, excluding fuel taxes, had grown at just 0.7% in FY14-FY17. A total sum of Rs 61.87 trillion was collected as GST receipts (including compensation cess) in the last five years, but states were still given Rs 8.2 trillion as compensation, including the transfers of Rs 2.7 trillion raised by the Centre as loan.

The five-year revenue protection for states was meant to counter-balance loss of their autonomous revenue space (VAT). States, to be sure, had agreed to an equal split in the GST revenue appropriation rights with the Centre, even though many fiscal policy experts had recommended a higher share for them. The Vijay Kelkar-led task force under the 13th Finance Commission, for instance, had said that 58% of GST revenue must go to states.

The current revenue buoyancy is attributable to compliance improvement and policies that cataylsed “formalisation” of the economy like GST itself. Efficient curbs on fake invoices, a system that allows disbursal of credits only after technology-enabled invoices matching and stronger audit trails have boosted revenues. Yet, if the states are looking for revenue growth similar to the last five years when certain high growth was guaranteed, they would be in for a shock. A shortfall of at least Rs 1 trillion on a combined basis is what they could expect in FY23 itself. Revenue protection has dented tax effort by states to an extent.

In a recent ruling, the Supreme Court reiterated that the Centre and states have simultaneous powers to legislate on GST under a cooperative federal structure. This has inflated the threat of revenue-hungry states tending to digress from the path of consensus largely followed by the GST Council. Any such fissiparous tendencies would further undermine the country’s indirect tax system.

GST 2.0 reforms must include bringing auto fuels, land and real estate under the tax’s purview, besides correcting other structural issues hampering seamless flow of input tax credits. This will help reduce overall tax rate and help unleash the factor market reforms necessary to bolster the economy’s productive capacity. The current global economic slump and concerns over macro stability may be constraints, but the new set of indirect tax reforms can’t wait for too long.

(With inputs from Prasanta Sahu)

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