February 22, 2006
The most memorable budget speeches are those that are animated by a single big idea. Manmohan Singh did that with economic reforms. Chidambaram did that with tax cuts. This year’s budget speech should focus on one big idea: the goods and services tax, so as to create an Indian common market.
In recent years, there has been an increased focus on difficulties of indirect taxes. The goods and services tax, proposed in 2004, is increasingly seen as a sound approach in solving these problems. The GST cannot be achieved immediately, but a lot needs to be done if we are to achieve a GST in the medium term. The two key pieces to focus on today are building a sound, IT-driven Central GST, and avoiding mistakes on the sharing of service tax with states.
India now has a current account which is almost half of GDP. This shows the enormous growth of international trade in both goods and services which has taken place. Looking forward, high growth in manufacturing exports remains a central element of an Indian growth strategy. As an example, India’s performance after the removal of worldwide textile quotas can best be described as lukewarm. The three big elements of the policy agenda required for India to conquer manufacturing exports are infrastructure, labour reform and the GST.
The first level at which the GST matters is in harnessing India’s internal economies of scale. The GST will help us achieve India as a common market. This will induce economies of scale, which are directly linked to higher GDP and greater international competitiveness. Equally important is the treatment of imports and exports. The first law of a globalised world is that you cannot tax foreign customers. The GST makes it possible for Indian exporters to receive a full reimbursement of all domestic taxes paid by them on their input purchases. Without this, Indian firms stand at a disadvantage when compared with the typical competitor who faces a sound VAT regime.
The GST is important in obtaining a level playing field between goods and services. It is not surprising that India has done unusually well in services, and not so well in goods, given that goods have received a harsh tax treatment. A key goal of the GST is that the government is blind to the identity of the activities of the firm, but merely requires a uniform VAT rate applied to all kinds of economic activities or firms.
Many wise thinkers are concerned about the administrative complexity of the GST. But today, we have a proven example of a highly similar system that is working fairly well. This is the income tax automation done through the tax information network (TIN). TIN handles tax deducted at source (TDS) from roughly 6 lakh Indian establishments — listed companies, unlisted companies, trusts, etc. The GST has to be enforced on exactly these establishments. The task of the TIN is remarkably akin to the work required for the GST: that of tracking tax deducted at source correctly across a large number of entities. The success of the TIN proves that India now has the management, technological capability and telecom infrastructure required to build such complex, nationwide systems.
A key goal of the GST is to reduce the compliance costs of companies. Our long-term goal should be to tell companies to only deal with two tax men: one for income tax, and one for GST. This requires mutual agreement between the Centre and states. The desirable structure is where central tax administration is the only contact point for large companies, for paying both the central GST and the state GST. Conversely, for small companies, the state tax administration should be the only contact point for paying both the central GST and the state GST. The two taxes would thus be harmonised but distinct.
While there is considerable support for these broad ideas, this climate of opinion now needs to be translated into specific actions. The most important single action that is immediately feasible is to merge the central VAT (CENVAT) and the central service tax into a single new tax which should be called the central GST. This should have a single rate applying to all large establishments. This should be implemented using an IT system like the TIN. The central GST should be charged on all imports. Exports should be zero-rated, so that exporters get a refund of their TDS on exports, through a smooth IT system with minimal transactions costs. Before the Centre takes on the difficult issues of dealing with fractious fiscal federalism, it should put its own house in order, by setting up a modern central GST. There is nothing which holds back the ministry of finance from setting course for this limited objective.
The second key action is to not make a mistake on the sharing of service tax with the states. The 88th amendment to the Constitution requires Parliament to pass legislation defining the sharing of service tax between Centre and states. If piecemeal sharing of services is done today, where states are assigned certain services which they can tax, then it will be an enormous setback to the idea of moving forward towards the GST. The only sensible path is to have states levying a state GST on all services, alongside the Centre. Thus there would be a central GST alongside a state GST applying to all large establishments.
Once these two aspects are under control, the stage can be set for moving towards the full integrated GST. There are several paths which could materialise. One possibility involves a meeting convened by the prime minister with all chief ministers in order to discuss the question, in a quest for a ‘grand bargain’ where all states shift into the GST. Another possibility involves states signing up, one by one, to participate in a common market where their state GST is harmonised with the central GST.
These scenarios need to be analysed and discussed in the coming one year. However, they do not require action today. The two actions which are required today are: building a world class central GST and not making a mistake on piecemeal taxation of services. Hence, this year’s budget speech should focus on one big idea, that of setting India on the path to the GST.
The writer is chairman, IDFC, and has headed key tax reform task forces
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