GST 2.0: A Good and Simple Tax it still won't be

The Goods and Services Tax (GST) was rolled out with much fanfare in a special midnight session of Parliament on 1 July 2017. The ‘one tax to rule them all’ was hailed as a landmark reform, but was more like a Faustian bargain.

The states surrendered their right to impose state-level sales tax, value added tax (VAT) and other levies such as octroi. While earlier, states could adjust these taxes to meet their fiscal needs, their ability to mobilise resources was now curtailed. State governments were ‘persuaded’ to surrender their autonomy with the promise of making good their tax shortfall (per the GST compensation clause, which expired in 2022.) Eight years on, states fear they will continue to face a huge shortfall in their tax revenues.

This Independence Day, Prime Minister Narendra Modi announced a “Diwali gift” in the shape of next-generation GST reforms, which he said were aimed at reducing the tax burden on the common people, especially the middle class and MSMEs (micro, small and medium enterprises). GST 2.0 would rest on three pillars: structural reforms, rate rationalisation and ease of living.

But let’s face it: as a unified, nationwide, indirect tax, GST has several drawbacks, from both the design and implementation perspectives. The design flaw is this: an indirect tax is inherently regressive. That’s because the tax paid does not depend on the income of the person, but rather on the value of the item being purchased. Hence, the poor feel the pinch of GST more than the rich.

GST revamp again sparks concern around fiscal autonomy for states

Direct taxes like income tax and wealth tax are more fair than indirect taxes. Fairness implies that the proportion of income paid in taxes should increase with one’s income, rather than decrease.

To reduce this unfairness, the GST was designed with multiple slabs. A zero or 5 per cent slab on items consumed by the poor, and a high slab for items consumed by the rich. This attempt to make GST fair — by using the consumption choices of the poor as a proxy for their income — is paternalistic. It implicitly dictates what poor people should consume, and does not factor in their aspirations. The divide between essentials and non-essentials is anyway neither sharp nor static, nor something that the Centre should determine.

With GDP growth, poor households move into the middle-income slab and middle-income households into the rich. Instead of targeting their income directly, the attempt is to ‘get them’ through GST.

Worldwide, food and medicines are exempt from similar systems of unified, indirect taxation. A rational, efficient system should have only one rate for all goods and services. This is seen in the EU, Singapore, Australia and other countries. There are some tweaks, but the broad principle is one median rate, one very low rate for essentials (food, medicine) and one very high rate for ‘sin goods’ (tobacco, liquor) and super-luxury goods.

Eight years of GST, still no tribunal for taxpayers

From an implementation perspective, the flaws in India are as follows. Multiple slabs, large swathes of GDP exempt, inverted duties and an excessive burden of compliance, especially on small businesses. The GST system in India has retained a complicated system of multiple tax slabs — 0 per cent, 5 per cent, 12 per cent, 18 per cent, 28 per cent, a penal sin tax rate and various cesses. This complexity leads to frequent disputes over the classification of goods and services, confusion among taxpayers and ensuing litigation.

GST-related legal cases have already clogged the system. The current GST structure is difficult to administer and regressive in effect. There are also cases of prevalence of inverted duty structures under GST, where inputs are taxed at higher rates than finished goods. This leads to credit pile-ups and cash-flow problems for businesses, and discourages domestic manufacturing.

Large parts of GDP — contributed by agriculture, petroleum products, electricity, alcohol and real estate — remain outside the ambit of GST. Selective exemptions fragment the tax base, reduce revenue and undermine the purported spirit of GST reform. The burden on small businesses and MSMEs is severe. Even when their customers can and do delay payments, they have to pay GST upfront.

There are also delays in refunds and other technical glitches which hurt business liquidity and confidence. Frequent changes in rates and rules, along with a complex filing system, pose additional burdens and lead to further tax litigation.

Under the proposed reforms announced by the prime minister on 15 August, the most significant change is the move from the current multi-slab GST system to a simplified two-slab structure: a ‘standard’ and a ‘merit’ rate, with special rates for a select few items.

This will hopefully make compliance easier, reduce both litigation and classification disputes, and bring much-needed stability and predictability to GST rates. Taxes on daily-use items and aspirational goods are expected to drop, boosting consumption and benefiting MSMEs. An advisable median rate would be 15 per cent, not 18, which is too burdensome. In fact, the GST median rate should come down from 15 per cent to 12 per cent as suggested by the 2002 Kelkar task force on tax reforms.

Finally, a comment on federalism. The Constitution assigns states greater responsibility for spending on areas such as health and education, but provides fewer independent revenue streams. GST has accentuated this imbalance, forcing states to rely heavily on Central transfers. To fund local development and public welfare, states need some autonomous taxing power.

The perception is that GST has undermined India’s federal spirit and eroded the fiscal autonomy of its states. We need to explore ways to grant greater fiscal space and autonomy to the states, enabling them to design policies tailored to state-specific economic, social and regional needs. Additionally, there is a need to tilt the balance away from indirect taxes toward direct taxes in order to reduce inequality.

Ajit Ranade is a noted economist. Article courtesy: The Billion Press