Many roads lead to a sound GST

by Vijay Kelkar and Ajay Shah, in the Business Standard, 17 October 2022

We are generally wary of the `silver bullet' policy solution, the elegant idée fixe which is supposed to solve a complex problem. But many problems that we see in the present Indian landscape can be solved by one reform: a correctly designed GST. The GST experience of recent years has helped clarify the mind around some of the basic improvements which are required, such as a uniform 12% rate. Cities are fundamental to the future of the republic, and they require an incentive compatible revenue base, a 2% slice of this GST. Difficulties of indirect taxation are hobbling investment into India, and the solution for that lies in the correct reform of indirect taxation.

A low single rate

The GST is widely criticised for underwhelming outcomes. Design problems have hindered the gains. The rates of 18 and 28 per cent are very high levels of taxation. Some individuals see the piling of a 28 per cent GST on top of a 42 per cent income tax, adding up to one of the world's highest levels of taxation. What works best is a single rate of 12 per cent, that is applied to all goods and services. This needs to go with a simple administrative system where every producer (even an individual) gets offsets correctly. We believe that a 12% rate will generate adequate tax revenues, but potentially after a few years this can go up slightly if this is not the case.

At a low rate, the incentive for evasion goes down. At a single rate, classification disputes are eliminated. Both factors reduce the level of conflict between the tax administrator and the people. In addition, a fundamental rethink of the operations of GST are required, to reduce the amount of legal/accounting/IT support required by each Indian firm.

Indirect taxation for a globalised world

There is great interest in improving the environment for private investment in India, and in attracting foreign investment in a context where many global firms are keen to reduce their activities in China. The indirect tax landscape contains a minefield of "disabilities" including inverted duty structures coming from the combination of cesses, tariffs, anti-dumping duties, FTAs and GST. India is a great place to produce, in terms of business potential. But there are infirmities in the Indian state, such as the tax policy and tax administration aspects of indirect taxation, which hold back the investment.

The complex and fluctuating indirect tax environment generates policy risk. For non-financial firms, the PAT margin averages just 6% of sales. A change in taxation that has an impact of one percentage point of sales constitutes 16.66% of the PAT. Therefore, small fluctuations in indirect taxes have big implications for the return on equity. The possibility of future fluctuations of any of the many numerical values of the indirect tax system creates policy risk. These large number of numerical values also create a political economy dynamic around lobbying for rate changes.

When PLI is brought into the picture, the PLI rate becomes one more number that can fluctuate, and thus a source of policy risk. There is a mean and a variance: the present numerical value of the disability (which can potentially be offset by a correctly calculated PLI) and the policy risk engendered by the indirect tax + PLI system (which is not solved by today's level of PLI). That policy risk hinders the investment decision.

Comprehensive indirect tax reform is the best solution. This involves three ideas:

  1. It is in India's best interests to unilaterally drive all tariffs / duties to near-zero levels. We should have three slabs of customs rates, of 0%, 1% and 2%, where the worst tariff rate (2%) can be stomached by firms when buying imported inputs without too much damage to their return on equity.
  2. All cesses and every other form of indirect tax needs to be removed; there should be only one single-rate GST.
  3. The GST needs to work correctly with imports and exports: All imports should face the GST-on-imports. `You do not tax non-residents', so all exports should be zero rated, and this should be implemented in a way that imposes no working capital requirements upon the taxpayer.

Once these things are done, there will be no need for a PLI.

We are at a unique moment in India's history, where major gains can be obtained by persuading global firms that India has rule of law, sound economic thinking and low policy risk. It is tempting to not take on these difficult problems, and make do with a PLI. But the PLI can at best solve the mean; it does not solve the variance, the policy risk, that is central in shaping investment decisions. Reform of indirect taxation solves both problems.

Incentive-compatible financing for local government

A critical element of a sound GST design is to lay the resource foundations for the third tier of government, i.e. local government. We should have a slice of the GST, 2%, which goes to the relevant local government. This creates adequate resourcing of the third tier, commensurate with the prime role of local government in producing public goods.

A slice of the GST that goes back to the city government is incentive compatible and improves the behaviour of the city government. The GST is a consumption tax. When economic growth takes place in a city, consumption in the city would go up, and 2% of the consumption within a city would go back to the relevant city. Self-interested politicians and officials would then be more inclined to foster growth, as this would directly feed their coffers. It would become possible to undertake borrowing to improve public infrastructure in the city, as the increased consumption at future dates would pay for debt servicing.

Getting the GST right

We are accused of being one track minds around our idée fixe, the GST, from 2003. But a correctly done GST is one of the most important solutions to some of the big problems of the country today, and it looms large in our imagination, 19 years into the journey. We should all put our shoulders to the task of getting it right.

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