The goods and services tax (GST), which will come into force on 1 July, is indeed a big deal. It needed a constitutional amendment to empower the Centre to tax goods beyond the production stage and the states to tax services, and this has taken a long time. Then finance minister P. Chidambaram, in his budget speech for 2006, set the target of moving a Constitutional Amendment Bill in 2010. It was moved by United Progressive Alliance finance minister Pranab Mukherjee in 2012, but could not be passed before the election. The National Democratic Alliance government took up the baton after coming to power in 2014. Fortunately, differences were resolved and the Bill was passed in 2016 with a unanimous vote in the Rajya Sabha, where the government does not have a majority. Indian parliamentary democracy can take a bow.

The GST will replace the present very complex system where the Centre levies a central excise duty on goods up to the production stage and a service tax on services while the states levy a state VAT (value added tax) on sales of goods, but do not tax services. Each of these taxes has a VAT (value added tax) structure, but they are applied on different bases. And in addition, there are a number of additional taxes e.g. the additional duty, special excise duty and various central cesses by the Centre and luxury tax, entertainment tax, octroi etc. by the states. All these taxes by the Centre will be subsumed into a single central GST and the multiple state taxes by the state into a state GST (legally a different tax in each state). These taxes will be applied on a common base and at the same rate for each commodity across the country. This is a major simplification which should be welcomed.

Also read | GST: A game changer for the Indian Economy

Is the current GST a good GST?

This is where the news is not good. There are more than 150 countries that have introduced VAT and this means there is a considerable build-up of professional experience internationally. These experts are agreed that the full benefits of a VAT are only reaped if the VAT is (a) near universal in coverage, with very few exemptions and (b) there are no more than two rates. Unfortunately, the GST Council, in its wisdom, has departed from expert opinion and given us a GST that experts agree is seriously flawed.

It is very far from being universal and according to some it excludes 50% of the gross domestic product. Major items such as petroleum, natural gas, alcohol, electricity, and real estate/construction are left out. Petroleum could be covered within five years. Residential apartments have been included but all other construction, including commercial construction and factories, is not. In addition, a very large number of commodities have been exempted. This suggests that revenue may fall short of expectations.

The second flaw is too many rates: 3% (on gold), 5%, 12%, 18% and 28 %, plus an extra GST cess on some luxury or socially undesirable items. Multiple rates are an invitation to misclassification and disputes/harassment arising from suspicion of misclassification. This reduces the efficiency gains which were expected to generate higher growth.

What is the impact of these weaknesses?

It is difficult to be certain but at the very least we should recognize that the positive effects will be less than initially claimed. A National Council of Applied Economic Research study that is much quoted had estimated that the GST would add between 1 and 2 percentage points to the economy’s growth rate. That was based on an ideal GST. Since what we have is very far from the ideal, the benefits will be correspondingly less. Perhaps a new study should be done to calculate the impact of the GST as it has emerged.

If revenues are lower because of the exclusions and the large number of items at a very low rate, the revenue loss will be entirely borne by the Centre. This is because it will not only have less revenue under the central GST, but it is also committed to compensate the states if their revenue grows at less than 14% per annum in nominal terms. This will have to be accommodated within the Centre’s fiscal deficit trajectory.

Despite these weaknesses, the GST will still be beneficial in many respects. The replacement of multiple taxes with a single rate for each commodity (taking Central and state GST together) is an advantage. The fact that the same rate will be imposed on all imports in addition to the normal import duty, is a major gain. It will level the playing field for domestic producers vis-a-vis imports because at present imports escape the state taxes, which erodes the protective benefit of customs duty.

Also read | All you need to know about GST

The elimination of border posts will be a major benefit. But we must ensure that the checking does not reappear in some other guise. The new law requires that all trucks transporting goods must carry an e-way bill which gives details of the goods being carried and the tax paid. This is an unnecessary burden since it gives tax authorities the power to stop trucks anywhere (not just at the border) to check if the e-waybill correctly reflects what is being transported. This could lead to tax authorities wanting to compare what is on the e-way bill with the contents of the truck—a potential source of harassment and corruption.

Will there be operational difficulties?

Many questions have been raised on possible operational difficulties. Will the GSTN (goods and services tax network) be trouble free or will there will be glitches?. Will the assessees be ready on time? These concerns are valid but should not be overdone. No new system is without glitches. The new system should be judged not by whether there are problems, but by whether the problems that arise are promptly corrected. The biggest problem in such situations is the danger that the system will not accept that something is a problem, because it might imply that it was poorly designed or preparation was poor.

There is, however, one troublesome issue which many tax experts have commented on, and which arises from the requirement that taxpayers must register in each jurisdiction in which they operate. If a unit operates in several states, it must register in each state in which it operates, and be taxed in each jurisdiction, and also maintain records that allow the tax paid in each jurisdiction to be audited. Banks, for example, operate across states and their fee-based charges will be taxable under GST by both the Centre and the states. It is not clear how taxes paid on inputs purchased Centrally by the banks will be set off against the GST on the final service provided. Allocation of Central expenditures across operations in different jurisdictions to allocate the input tax involved will be very difficult.

The GST was meant to unify the country into a single market. This means more and more organizations will set up in different jurisdictions and will need to operate seamlessly across them. A single registration valid across all states would have been the right thing to do. There is no economic justification for the insistence on treating each unit operating in a state as separate unit except that it will put them in the net for audit by the state agency. This is not a vested interest of the state. It is a vested interest of the state revenue administration.

Can we remedy the situation?

The short answer is that we can, provided we recognize that the birth of the GST is only a beginning. A systematic effort should be launched to correct deficiencies over time through the mechanism of the GST Council. This is a unique experiment in cooperative federalism. Contrary to what is said in the press, it is not the new sovereign taxation authority. It remains a recommendatory body on the basis of which the Centre and the states will modify the tax system but it is an ideal body to build the necessary consensus.

The GST Council should set up an expert group that could assess the performance of the system based on results of the first year and work on a revised GST rate structure to be implemented after the general election in 2019. One of the terms of reference of the group should be to pronounce on the desirability of migrating to fewer rates.

Also read | How GST impacts auto, real estate, telecom and retail sectors

According to press reports, Central government experts were in favour of fewer rates but state finance ministers insisted on greater differentiation to achieve progressivity. Using differentiated rates of indirect taxes to achieve progressivity is widely supported as a sensible objective but is actually mistaken. Progressivity should be considered not in terms of particular taxes but the progressivity of the fiscal system as a whole, including the direct tax system and the progressivity of public expenditures. Viewed from this perspective, insisting on exemptions and low rates of tax like 5% does not really mean that the tax burden is greatly reduced. Exempted items bear the taxes on inputs which are built into the cost and the price. Low taxed items also already bear taxes on inputs, and while it is good to bring them into the tax net, they could easily be taxed at a higher rate, say 8%. These issues should be thoroughly studied by an expert group which can submit a full report to the GST Council in a year’s time.

The case for an independent secretariat

Persuading states to agree to changes over the next two years will require persuasion and evidence-based analysis. For this, the GST Council should be serviced by an independent secretariat which can undertake or farm out studies that may be desired by state finance ministers, and also comment on studies that may be put before the GST Council by either the finance ministry, or any of the states. The secretariat should be headed by a secretary-level officer reporting to the chairman of the council, i.e. the finance minister. The Central government revenue department has a great deal of expertise, but for it to service the GST is inconsistent with cooperative federalism. A separate secretariat, with people taken on deputation from the Centre and the states, and with outside experts brought in as consultants, would be ideal.

Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.

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