Opinion A regime too patchy

Late last month,the empowered committee of state finance ministers met in Shillong to discuss the goods and services tax (GST). It asked the Centre to keep taxes on petroleum products,liquor and entry of goods out of the GST’s ambit. It also asked the Centre to devise a constitutional framework to compensate states for any loss of revenue due to the introduction of the GST.

The old excise-based tax system in India leads to a cumulative effect of taxes on inputs multiplying the taxes on outputs,which cascade through the economy and add to the cost of production,thereby disadvantaging exports. Under a proper GST,this cascading would be removed,and exports would be free of taxation. This will not happen in India if certain goods are exempt from the GST (so that states can levy their own taxes on them). Exemptions do not permit taxes on inputs to be fully offset against those on outputs. The proposal for a unified authority to implement an integrated GST makes perfect sense in an increasingly competitive world.

With the economic crisis,many European countries have moved towards the value-added tax (VAT) framework,which does not discourage exports. In China,the centrally administered shared VAT is rapidly replacing provincial business sales taxes on key services such as transport and telecom. Substantial reductions in the tax burdens of firms have been demonstrated as a result,improving the competitive position of the economy.

India has suffered due to the continuation of the colonial system,which split the main tax bases between various levels of government. This severely handicapped the design and implementation of a GST. As Satya Poddar and I had argued in a submission to the last Finance Commission (“GST Reforms and Intergovernmental Considerations in India”),the Indian GST has three main disadvantages. First,the distinction between goods and services is becoming increasingly untenable. Second,cascading emerges due to exemptions and gaps in tax bases. This vitiates the GST’s main advantage. Third,complexity is a serious drawback. Multiple administrations increase the burden of compliance on companies and traders.

Exemptions also lead to a loss of information. This facilitates evasion from both the GST and income taxes,adding to the incentives of informality,as in both Mexico and Pakistan. Mexico has recently acted decisively to fix its VAT by eliminating exemptions (apart from on unprocessed food) and multiple rates in order to generate more efficient production and export possibilities. The information generated by the VAT is also expected to increase income tax collections without the need to increase rates and reduce informality and cheating. Exempting unprocessed food does not affect the information chain and,together with the introduction of a universal pension,largely took care of distributional concerns.

A unified administration,such as that proposed in India,does not ensure exemptions and holes will not creep in to “protect” this sector or that. This is shortsighted and should be avoided at all costs. While exemptions provide some relief to specific sectors relative to others,they reintroduce cascading and make

the whole system more inefficient. They also give rise to demands for further exemptions to compete with trading partners.

The Australian model provides an appropriate precedent for India,although there are issues of overall revenue generation and state-level autonomy. In Australia,the single administrative authority for the GST was facilitated by an agreement that all resources collected would be returned to the states through the equalisation framework of the Commonwealth Grants Commission.

In India,the states’ share of the GST could be returned to them under a framework to be devised by the Finance Commission — whether on an equalisation basis or not is another issue. To the extent that the efficiency of collection is improved,the tax to GDP ratio increases,thereby benefiting all states significantly.

But the issue of state-level tax autonomy remains. A more appropriate instrument for this is for states to impose a surcharge on an integrated income tax. Removing petroleum goods from the integrated GST is a bad idea. However,a state-level piggyback or a surcharge on a Central carbon tax is a possibility,as argued in my paper with Nicholas Stern (“Effective Carbon Taxes in India”). The issue of a state-level tax on liquor is more acceptable,as it is largely a final consumption good. However,industrial alcohol must

be subject to the GST.

Ensuring that no state loses from the reform is important — and is needed for political economy considerations. This requires a linkage with the transfer system. A similar provision was critical to ensuring provincial support for the shared VAT in China in 1994. It should appropriately be an important issue in this fundamental reform in India.

The writer is visiting senior fellow at the LSE Asia Research Centre,UK.