Let me wish all the readers of The Financial Express a very happy new year. I am resuming my column after two years when, as a member of the Finance Commission, I had avoided commenting on contemporary public policy issues. In this column, I explore the challenges of prospects of a major domestic trade tax reform, i.e., the introduction of the goods and services tax (GST).

At the outset, the Union finance minister must be complimented for putting the GST reform agenda back on the table and persuading the states to move forward on the reform. I had, in an earlier article likened GST reform to a bullock cart stuck in the mud, and with passage of time, the wheels had stuck deeper in the wake of tremendous trust deficit between the Centre and the states. Agreeing to pay the compensation for the reduction in the Central sales tax (CST) helps to roll the wheels. To avoid controversy on the amount, it may be desirable to ask the Comptroller and Auditor General to provide firm data on the CST collections.

Expectations of the gains from GST have been optimistic. The industry has characterised this as a game-changer. The finance minister himself has stated that this is the single-most important tax reform of the century. The academic support for this comes from the NCAER study done for the 13th Finance Commission in which, the reform is estimated to accelerate the growth rate of the economy ranging from 0.9-1.7 percentage points. The gains arising from lower distortions due to broader base, lower rate and less differentiated rates, benefits of seamless trade across the country, greater export competitiveness due to comprehensive relief of domestic taxes on exports, and lower administrative and compliance costs are seen as the gains.

Such optimism about the GST reform, however, would be misplaced for a variety of reasons. In a federal set up, when the power to levy the sales tax is assigned to the states, the GST that will ultimately emerge will be the outcome of bargaining between the Union, 29 states and 2 Union Territories (UTs) with legislatures on the one hand and among the states and UTs on the other. The interests of the Union and state governments do not necessarily coincide nor are the interests of producing states in harmony with those of the consuming states. There is a trade-off between tax harmony and fiscal autonomy and therefore, the ultimate GST structure that will emerge will be a compromise solution. The NCAER study bases its estimate of productivity gains by assuming the model GST designed by the Task Force of the 13th Finance Commission and there is no way the states will agree to that structure. Besides, the study is based on the input-output table of 2003-04 and therefore, the estimate subsumes productivity gains from the introduction of VAT by the states in 2005-06, which was an important reform replacing the cascading sales taxes of multiple rates with the value-added tax with two rates.

The difficulties in achieving a flawless GST are already visible in the Constitution Amendment Bill submitted to Parliament. Continuation of the CST at 1% is clearly against the spirit of ensuring a common market and destination-based GST. Similarly, lack of clarity with regards to subsuming excise duties in alcohol, purchase taxes on foodgrains and taxes on petroleum products have come to the fore. Some of the states have already commented on the haste in submitting the Constitution Amendment Bill to Parliament.

Even if the government is able to carry through the amendment, there are a number of issues on which the Centre and the states are yet to be in agreement. The states would like that the Union government should continue with the exemption limit for Central GST at R1.5 crore as any lowering of the limit would bring the small dealers into the Central as well as States GSTs instead of just the state GST they are paying at present. However, that would limit the expansion of the tax base of the Centre. In addition, agreements have to reached on the exemption list, items to be subjected to lower-rate category, general rates of Central and state GSTs, the mechanism for providing tax credit on inter-state transactions, the details of implementing place of supply rules with regards to inter-state services, harmonisation of the tax administration, the training of tax administrators at the Centre and states and of course, the mechanism for compensation. On the last issue, the Centre has agreed to pay the compensation for the revenue loss fully for the first 3 years, 75% for the fourth year and 50% for the fifth year. Although some discussions have taken place in regard to these, consensus is yet to be reached. Border transactions are always a problem area and are a source of tax evasion even in the European Union. Similarly, implementing the place of supply rules and e-commerce transactions can pose severe administrative challenges. After the structure and operational aspects are finalised, the technology platform has to be erected to ensure smooth and seamless tax credit mechanism. Training the tax administrators to deal with the complex set of issues and assisting the taxpayers with friendly services needs to be planned and implemented.

The problem is, over the years, the Central government has not shown the required leadership role in reforming its own indirect tax namely, the excise duty. The Expert Group on taxation of services had, in 2001, indicated that the Centre should extend the base of service taxation to all services with a small negative list and after getting a firm estimate of the base in the next year, should have a common threshold and unify the rate to move over to the GST at the manufacturing stage. This reform did not require any Constitutional amendment and would have helped to clean up the indirect tax at the Central level. It took over ten years for the Central government to move over to the negative list. Rather than unifying the excise duty rates, the rates have only diverged over time. At the state level too, there is a shortcoming in the structure of present VAT and remedying this can improve the tax compliance appreciably. The major advantage of VAT is that it provides input tax relief. Since this relief is given, there is no reason to tax inputs at a lower rate than the outputs. In the present system, major raw materials are taxed at 5% as against the finished goods being taxed at 13.5% provides enormous incentive to purchase the inputs by paying 5% tax and suppress the output value to gain a clear difference of eight percentage points in taxation. The states should remedy this birth defect.

Considering the complexities of the tasks and the fact that the interests of all the parties are not single-peaked, it would be too optimistic to expect the GST to be a game-changer. We should peg our expectations on GST realistically as the next stage of reform of domestic trade taxes in India. This reform is not an event; it should be taken as a process. The quality of the GST reform will put to test the statesmanship of the leadership at both the Central and the state levels.

The author was a member of the Fourteenth Finance Commission and is Emeritus Professor, National Institute of Public Finance and Policy