The economics of GST, hostage to politics

GST will make it possible to integrate India into a common market

The complicated political bargaining that has held up the introduction of the goods and services tax (GST) as well as the arcane discussions about its revenue-neutral rate sometimes draws attention away from the big picture argument about why the Indian indirect tax system needs to be overhauled.

A new paper released this week by the finance ministry on the GST structure does a very good job of explaining the current view on some of the more technical parts of the debate. But it also shows how several years of political bargaining has diluted the original design of what a 2009 report by the task force headed by Arbind Modi repeatedly referred to as a flawless GST.

One result is that the revenue-neutral GST rate, or the rate that will leave the government with the current level of tax collections even after moving to the new tax, has gone up by some 3.5 percentage points compared to the 12% originally suggested in 2009, with 2% of it meant for the third tier of government.

The analytical arguments for the GST are powerful. It will generate efficiencies by, in effect, taxing only final consumption while eliminating all taxes on production and distribution. The abolition of taxes on the movement of goods between states will end the unnecessary fragmentation of Indian production. The efficiency of the tax system would be optimized. Many of these points have been drilled into the national debate by economists.

The way the finance ministry has framed the issue in its new paper is definitely interesting. Two big political points have been made. First, a GST will improve governance by creating incentives for the reduction in corruption.

For example, a company will need documentation from a supplier if it is to claim tax credit, and in general, the new tax will create a proper paper trail of transactions across value chains, reducing the black economy. It thus stands to reason that real estate, a fount of corruption, must be brought under GST.

Second, and this is something that GST supporters have argued all along, a tax with a single rate and imposed on a common base will in effect integrate India into a common market, more than six decades after political unification into a republic. The advantages of a single market are thus not only economic but also political, while the dual structure of the Indian GST will ensure that the states maintain their fiscal independence (though this newspaper would also like the initial idea of a share of GST revenue going directly to cities and villages to be pursued more energetically).

There are still two tricky issues. The 2009 report by the Modi committee had quite explicitly argued that the switch to a flawless GST would benefit the poor and not be regressive. Arvind Subramanian and his colleagues at the finance ministry, on page 28 of their new report, seem to be explicitly making the opposite point. “It is worth emphasizing that the GST is intrinsically a regressive tax and the higher the rate, the greater the regressivity.” This is a tactical argument for keeping the GST rate close to international levels, but also means that India needs to increase its direct tax collections to ensure that there are no perverse distributional effects in its overall tax system.

It is now more than a decade since a national value-added tax was first proposed in 2004 by a task force appointed to examine the implementation of the landmark Fiscal Responsibility and Budget Management Act of 2003. It is fair to say that India will not end up with a flawless GST, but at least silly ideas like the 1% tax on inter-state transactions should be buried.

The GST bill is once again being held hostage in parliament, despite there being broad bipartisan agreement about its necessity, this time by an independent court decision in the National Herald case. National interest is once again hostage to the politics of the day.

Should the opposition parties cooperate with the government in passing the GST bill during
this winter session?