India will launch a new national sales tax as planned on July 1 to boost economic growth and state revenues. The country has one of the most complicated tax systems in the world with the central, state and local governments constitutionally authorised to levy taxes.
Since independence, the Indian economy has been negatively impacted by this complex and inefficient indirect tax system. For one, the multi-stage structure causes the cascading effect of taxes resulting in increased costs to the producer and consumer. Secondly, interstate taxes create barriers within the country resulting in an economically fragmented national market.
The Goods and Services Tax (GST) is expected to address these critical issues among others. Since the GST is such a major reform that would transform India’s $2tn economy into a single economic zone, getting the tax structure right is critical. The GST Council, chaired by the federal finance minister and comprising finance ministers of all states, has decided on a four-tier GST tax structure of 5, 12, 18 and 28% for goods. However, in reality there are seven rates: 0% for essential commodities like food grains, 4% for gold, 5% for goods of “mass consumption” like tea and spices, two standard rates of 12 and 18% for the majority of items, 28% for white goods and cars, and 28% plus cess for luxury cars, tobacco products and aerated drinks. Most services are likely to fall under the 18% tax slab.
This newly proposed tax structure contradicts the core objective of introducing the GST in India, i.e., overcoming the complexity and inefficiency of the current system in order to simplify tax administration and ensure higher compliance. At the same time, the proposed multi-tier tax structure could increase the costs of administration and hamper compliance; it would require new and much more complicated record keeping, and it could create opportunities for tax avoidance through misclassification.
More importantly, the GST structure provides incentives for the private sector to lobby for their products to be shifted to a lower tax slab. This provides unprecedented power to the Finance Ministry bureaucrats in Delhi who will have a stranglehold over private companies.
For the GST to truly reform India’s complicated tax system and eventually increase the GDP growth rate by 1-2% (as argued by the finance minister and many economists), the government should initially implement a two-rate structure with a demerit rate, and strive for a single rate in the long-term. The lower rate should be around 12%, the standard rate around 16-17%, and the demerit rate around 40%. Having the lower rate close to the standard rate enhances compliance and reduces incentives for industry groups to seek tax advantages. The seemingly high demerit rate is in line with existing rates to ensure revenues are preserved. The GST regime should also include minimal exemptions to avoid political discretion and economic distortion. To address specific socio-economic equity concerns, the government should attempt better targeted instruments like direct benefit transfers.
The GST is India’s most ambitious tax reform with transformative potential. It can improve tax governance with its self-policing nature and dual monitoring mechanism, boost domestic manufacturing by economically unifying the country, and increase investment by removing capital goods taxation. However, the tax structure proposed by the GST Council will merely serve as a name changer rather a game changer.
Since the GST is such a major reform with transformative potential, getting the tax structure right is critical