India’s central government remains committed to introducing a unified and simplified goods and services tax by April 2011. No firm agreements came out of the latest round of negotiations with state governments, which remained wedded to the “pork barrel” and the local advantages of all the various tax-induced distortions in India’s internal market. But with the government’s overall reform credibility at stake, Finance Ministry officials are not giving up.
The central government was forced to delay the transition of India’s indirect tax regime to the planned unified goods and services tax (GST) by one year to April 2011 after failing to reach agreement with India’s 28 constituent states on how the new system will work. But with only 10 months to go before the new deadline, the central and the state governments have yet to make headway in resolving basic issues such as the new tax rate, the tax base and the threshold (defined as the size of turnover above which businesses would be subject to the new tax). A meeting between the centre and the states on 21 May, the first since the start of the current fiscal year, concluded with the centre offering higher compensation to the states for going over to the GST. But no agreement was reached on the major issues.
At stake is the central government’s credibility in terms of its willingness and ability to push through important reforms. And few reform challenges can compete for fundamental importance and urgency with structural improvement of public finances.
The government’s fiscal targets originally enshrined in the 2003 Fiscal Responsibility and Budget Management Act have been blown out of the water, owing not only to the orthodox counter-cyclical fiscal loosening following the 2008 global financial crisis but also to political reluctance to curtail wasteful subsidies and unproductive expenditures. The aggregate budget deficit of the central and state governments more than doubled to 9.7 per cent of GDP in FY2010 from 4 per cent just two years before. In his February 2010 budget Finance Minister Pranab Mukherjee projected the central government’s deficit at 5.5 per cent of GDP in FY2011, an improvement over the 6.9 per cent in FY2010. But that is still a far cry from the target of 3 per cent of GDP that the government was legislated to achieve by FY2009.
The government has shown renewed enthusiasm in the past few months for pushing through measures that will help to narrow the budget deficit. It wrapped up a very successful auction of 3G telecom licences in mid-May and is conducting another auction of Broadband Wireless Access spectrum licences that together could rake in revenues exceeding 1.5 per cent of the official FY2011 GDP estimate. Other planned one-off measures to reduce the deficit include selling minority government shareholdings in companies such as Engineers India, Coal India, the Steel Authority of India and Hindustan Copper to private investors. These sales are expected to raise Rs400 billion (US$8.6 billion) in FY2011.
However none of this can substitute for structural fiscal reforms. The government has also made some progress in this regard with steps including a fertilizer subsidy reform and an increase in natural gas prices for the first time in five years. But critical measures such as the deregulation of fuel prices, still stalled at time of writing, and the implementation of the GST are necessary if the government is serious about its fiscal roadmap of reducing the deficit to 4.8 per cent of GDP in the next fiscal year and further to 4.1 per cent in FY2013. The GST has been talked up as one of the biggest structural fiscal reforms in India’s recent history – in the government’s own words it is a “game-changing tax reform”.
The planned GST amounts to a thorough rationalization and simplification of India's labyrinthine system of indirect taxation. A complex web of existing indirect taxes, such as the service tax, excise duty, VAT, local taxes, central sales tax and purchase tax, will be swept away. The proposed tax will be levied in parallel by both the central government and state governments. In view of India’s heavy dependence on indirect taxes (at 12.7 per cent of GDP in FY2009, they are among the highest in the world), the GST is not merely a shake-up of indirect taxation; it is a radical overhaul of the entire tax structure.
The structure of the GST under consideration comprises two components: one for the central government and the other for the states (a similar federal model is followed in Brazil and Canada). The tax rate under this dual GST will still be lower than the multiple indirect taxes currently being levied. As a result the prices of most goods will come down as producers pass on lower costs to consumers. But there may be short-term increases in the prices of some services, as the GST rate is likely to be higher than the current levy of 10 per cent on the service sector.
From a fiscal point of view, the potential benefits of the planned GST are of the best kind because the gains stem not from tightening per se (the idea is to achieve a revenue-neutral effect from reductions in tax rates and the incidence of tax liability offset by broadening the indirect tax base) but from the way in which this new tax should promote efficiency. The end result would be higher potential growth rates, thus stronger budget revenues.
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1. Reduced number of taxes at both the central and the state level |
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2. Removal of the cascading effect of taxes |
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3. Lower effective tax rate for many goods |
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4. Simpler tax compliance, reduced transaction costs for taxpayers |
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5. Increased collections owing to a wider tax base and better compliance |
Source: PricewaterhouseCoopers.
A major efficiency gain at the company level will result from eliminating the effect of “cascading” taxation whereby one and the same product is repeatedly taxed, leaving companies with the challenge of claiming refunds (“offsets”) of taxes already paid – a procedure that is cumbersome and sometimes impossible. The National Council of Applied Economic Research (NCAER), a New Delhi-based think tank, estimates that non-offset indirect tax could be around 20–30 per cent of India’s total tax revenue. In addition the new tax system will remove any bias in input purchase decisions made by producers, as all goods and services will be brought under the tax net.
The NCAER expects efficiency gains from the GST to increase goods and services exports (which together account for a quarter of India’s GDP) by Rs247–487 billion (US$5.2–10.2 billion) or 3.2–6.3 per cent. As for the general impact of the new tax, it estimates that the GST would have increased India’s nominal FY2009 GDP by 0.9–1.7 per cent. In absolute terms (based on the revised FY2009 GDP figures, that would be Rs502–948 billion (US$10.7–20.2 billion).
GST enthusiasts argue that the revenue-neutral rate for the new tax should be relatively low. The NCAER puts that rate at between 6.2 per cent and 9.4 per cent while our trusted source (see the next sub-section) prefers the top end of that range. For its part the Finance Commission, a body appointed every five years by the government to recommend the division of revenue between the centre and the states, believes the rate should be 12 per cent. These views on the tax rate are predicated on an efficient tax system, which would have a minimal number of exempt goods and services; a wider tax base, which also includes certain services that are not currently taxed such as real estate services; and a minimum turnover of Rs1 million (US$21,000) for a business to be taxed.
These are the controversial areas being debated in centre–state government negotiations over the GST. Both the centre and the states want higher rates of taxation, with the states bargaining for the maximum rate possible amid fears of losing revenue. No specific rates have been proposed yet but those being bandied about range from 16 to 20 per cent. Such elevated rates would not be viable for smaller businesses (for example, retailers) and for companies trading basic goods such as food products. As a result the government would have to exempt certain products from the tax net, which would again create distortions and tax loopholes. The central government proposes a turnover threshold level of Rs1 million (US$14,760), below which businesses would not be liable for this tax, but the states want sole power to tax businesses with a turnover of less than Rs150 million (US$3.2 million), which would mean large revenue losses for the centre.
At the core of the disagreement between the centre and the states is the anticipated shift in the balance of power. The states will lose autonomy over tax policy owing to the proposed uniformity of the GST and in turn will not be able either to increase taxes in order to raise additional revenue or to dole out tax concessions so as to win popularity among voters. In an effort to bring them round, the central government in the 21 May meeting gave into the states’ demands for higher compensation owing to a loss in tax revenue than the previously proposed Rs500 billion (US$10.5 billion) spread over five years, from FY2011 to FY2015.
Satya Poddar, Partner in the Tax Policy Advisory Group, Ernst & Young
Even the bolder claims being made about the benefits of the GST could well prove to be justified, and analysts could be underestimating the positive fiscal and political impact of the new tax.
The loss of autonomy and state discretion on taxes would benefit the Indian economy as a whole. However fears of political losses are making several states reluctant to agree to the new tax structure. If it is implemented properly, all the political games being played in framing tax policies will stop. The current tax policy is ad hoc and lacks transparency. The GST is ideal, as it will harmonize centre–state tax policy and prevent states from acting like Santa Claus in either giving concessions or exempting certain goods and services from tax.
But the central government needs to guard against two basic flaws that could result in a less than optimal tax structure: continued concessional rates or outright exemptions for certain goods and services and the levying of multiple taxes. The latter creates distortions because it is difficult to determine the stage of production at which a product should start being taxed. For instance, if milk is tax-free, then the government has to decide whether to exempt flavoured milk, skimmed milk, plain yoghurt and other milk products as well. On tax rates, the central and state governments are considering a suggestion for two rates for food products, with a lower levy on essential commodities. The states also want a broader range of products under the lower tax rate. However the definition of what is essential varies from state to state, depending on cultural and dietary habits.
Every business is extremely positive about this tax – unlike when VAT was introduced in 2005. Some businesses that were reluctant to switch over at that time have since been pleased with VAT’s performance. Getting left out of the GST will increase costs, as companies will not be able to claim credits on taxes paid on inputs used. With 10 months to go before the April 2011 deadline, doubts persist about whether the central government and the state governments are proactively putting a programme for the GST roll-out in place. The final law for the GST should be cast in stone at least six months before implementation so that businesses as well as the administrative machinery are ready. If the government can finalize draft legislation by October and enact it along with the required constitutional amendment by January 2011, the GST could be rolled out in time for the start of the next fiscal year.
Despite some signs that Finance Ministry officials and others closely involved in the GST are focused on meeting the April 2011 deadline, the effective failure of the latest centre–states negotiating round points to at least another year’s postponement. Little progress has been made so far towards creating the basic building blocks of the GST. Persistent differences between the centre and the states on various critical issues, such as rates, coverage and threshold levels of the tax, still need to be ironed out. Worries over a sub-optimal GST were a major reason for the first postponement of the introduction of the new tax from April 2010 to April 2011.
There is of course a chance of the Finance Ministry pulling out all the stops so as to enable draft legislation to be ready by October. This, as pointed out by our trusted source, is the first hard milestone in the revised timetable. But for now, it appears that this could be achieved only at the cost of a sub-optimal structure, begging the question of whether a second 12-month postponement might be reckoned a lesser evil.
A judgment on that point will be possible only after negotiations are further advanced. Much will depend on how accommodating the central government will be to states’ demands for higher tax rates, multiple levies, various exemptions and higher threshold limits. It appears motivated to keep the ball rolling, as reflected in the offer tabled by the Finance Ministry in the 21 May negotiating meeting to provide states with a larger amount than the Rs500 billion (US$10.7 billion) previously suggested to compensate for any revenue losses caused by the transition to the GST. However the maximum compensation amount is yet to be decided.
If the GST project is undermined or diluted, this will be the work of politicians at the state level rather than the result of business lobbying. Businesses across the board are supporting the transition to the GST (even the services sector, for which the tax rate is likely to rise from the current 10 per cent) owing to the longer-term advantages of this tax. If the tax is implemented in a reasonable manner – at a rate not exceeding 14 per cent and without too many exemptions – it should boost equity investor sentiment, as markets have not yet fully priced in the benefits because of the uncertainty still surrounding the details of the new tax and the way in which it will be applied.
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