The critical element that helps formalisation is its input tax credit mechanism.
Ever since GST was implemented on July 1, 2017, a number of changes have been made in a series of meetings by the GST Council to make the system more rational and operational. Of course, in most countries where GST is introduced, it takes time to settle down, and changes are mostly to do with operational details. The changes that have been made in India have been far more frequent and basic, dealing with both the structure and operational details. Changes have also been made on the threshold, limit for composition, periodicity and simplification of returns, particularly for small tax-payers. The two important reasons for this have been our inability to move away from the past and inadequate time for the preparation of the technology platform.
The latest announcement of reduction in the rates of GST for under-construction houses to 5% and affordable houses to 1% has received mixed reactions. While some have hailed it as ‘boost to real estate’, others have stated that it is ‘a patchwork approach’ and does not qualify to be called a GST without input tax credit. Having experienced the functioning of GST in the country for the last 20 months and seen the frequent changes that have been made, it is important to learn lessons from the past and make changes in a calibrated manner to settle down to a stable GST regime without violating its fundamentals. The most important advantage of GST is its transparency and self-enforcing nature. It is also important to see that the reform helps in the formalisation of the economy. The critical element that helps formalisation is its input tax credit mechanism.
There is nothing wrong in making calibrated rationalisation of the tax as we gain experience. However, as mentioned earlier, the number of changes and their frequency depends on how well we have structured the tax in the first place. In the case of India, the basic flaw was the number of rates and the way in which various commodities and services were ‘fitted’ into different rates. The committee under the chairmanship of the then Chief Economic Adviser for determining the rate structure recommended a “high rate” of 40 percent on demerit goods in addition to a low rate and a standard rate. The Committee was perhaps not sure that the two rates will be revenue neutral and therefore, introduced the third rate. Eventually, the GST Council decided to have five different rates of 0%, 5%, 12%, 18% and 28%. It later introduced two more rates—0.25% on rough diamonds and 3% for gold. In addition, for compensating the states for any loss of revenue, it introduced cesses at three different rates. The “fitment committee” of the GST Council seems to have added the earlier sales tax rates with the Union excise duty rates and fitted the commodities to the rate that is the closest. In the process, it lost the opportunity to rationalise the rates by by avoiding the defects of the previous tax regime.
Writing on GST in 2001, I had stated that there is no unique GST—it is neither a “Gorilla, nor a Chimpanzee but a Genus like Primate” (EPW. February 12, 2011). Each country should adopt the structure it considers appropriate, but the fundamental character of the tax must not be compromised. In choosing so many rates, the tax got complex, created classification ambiguities and, often, input tax credit exceeded the output tax payment giving rise to an inverted duty structure. In fact, the defects of the earlier sales tax system where inputs were taxed at lower rates than the outputs giving rise high incentive to evade the tax by suppressing the output value. In GST, since input tax credit is given when the output is taxed, it is inappropriate to tax inputs and outputs at different rates. The ideal structure that IMF recommends is one rate, but many countries levy the tax at two rates—a lower merit rate and the general rate. If articles of sumptuary nature need to be taxed at high rates, a separate excise tax is levied. However, India is unique in having so many rates and this is bound to create complexities as mentioned above. As the rate fixation has been done in a mechanical manner, there will be many more changes. Of course, the past legacy may not permit us to have one rate of GST, but a structure with too many rates merely on the grounds that it existed before and our common ‘belief’ about necessities and luxuries without knowing their employment intensity cannot be considered rational.
The GST Council has shown a remarkable flexibility in making some important changes. In particular, reclassification of a number of items taxed at 28% under 18%-category is truly welcome and, hopefully, the 28% category will be done away with altogether in not too distant a future. Over time, it would be useful to converge the 5% and 12% rates into one rate of 10% to substantially simplify the system. Much remains to be done to make the rate structure rational and perhaps, the GST Council should have a secretariat, with members having strong domain expertise to undertake research to improve the tax system. The patchwork changes will only complicate the tax system further.
In this context, the decision to reduce the tax rate for under-construction houses to 5% and affordable houses to 1% is retrograde. In the earlier system, GST for under construction houses was levied at 18% and with one-third value for land assigned, the effective rate was 12% and the tax on affordable housing was 8%. This has been brought down to 5% and 1%, respectively. Clearly, housing is a heavily taxed sector. Besides varying rates of stamp duty across states, we also have a capital gains tax. Given the high cumulative incidence of taxes on housing, the rate of return for remaining informal and undervalue the property transactions to evade the taxes is high. More importantly, the Council should have seen that many inputs such as cement, marble, granite and paint are all taxed at 28% which add to the input cost enormously and not giving input tax credit will not only result in high costs but also low compliance. The suppliers of these inputs may collude with the builders to suppress their sales and discontinuing the input tax credit will not leave any paper trail. In other words, rather than making the system formal, the recent changes will simply help in making the housing market even more informal. Perhaps, the Council should have brought down the tax rate on inputs mentioned above from 28% to 18% or even 12% to avoid the high burden on the construction industry. This would have simplified the tax, retained the paper trail and avoided the inverted duty structure. To avoid such patchwork approach, the council needs a strong secretariat with domain expertise.
The author was Member, Fourteenth Finance Commission. Currently, he is a Counsellor, Takshashila Institute
Views are personal