As India’s Goods and Services Tax (GST) ends its five-year anniversary on June 30, it has, at best, just begun to show flashes of innate brilliance. Receipts have been very dynamic in recent months, so that the Center now expects receipts from this main indirect tax for the current financial year to be one-fifth higher than the provisional budget (BE) announced in February . In the past fiscal year, inflows grew by a solid 30.5%, albeit on a contracted basis (-7%).
The GST, however, produced suboptimal results over the half-decade, mainly due to its serious design flaws and ad hoc policies. The period has nonetheless testified to the fact that even an imperfect GST can be vastly superior to the larger cascading assorted indirect tax system it replaced.
As a destination-based consumption tax, the GST was expected to result in additional revenue productivity and a significant “production effect”, as taxation is limited to only value added at each stage and B2B transactions take on a virtual transfer. These gains were hard to detect, at least until recently (the ratio of GST revenue to GDP was around 6.3% in FY19 and FY22).
There is also no convincing evidence of a sharp reduction in the tax incidence on capital investments and production inputs giving a boost to the economy, although this too has been one some promises.
Meanwhile, since the pandemic warped the economic landscape, the opposing views on the effectiveness of the GST have remained just that: views.
To be fair, it was a daunting task for the then finance minister, Arun Jaitley, to strike a deal on the structure of GST with the state governments after striking a big bargain. Implicit in this agreement and the laws that soon followed were major changes in the way administrative powers and revenues are shared between the Center and the states and the states among themselves.
What was best possible was done, and it was an era in itself. All major elements of indirect taxes collected by the Center and the States, except the basic customs duty (import tariff), collapsed in the new tax. But large parts of economic transactions were kept outside its jurisdiction, including motor fuels, natural gas, land, real estate (construction for factory and public works), alcohol and electricity. . As a result, sectors of industry, including steel, cement and transportation, cannot obtain full credit for input taxes paid while meeting their output tax obligations.
Taxes continue to be paid on taxes. Economic setbacks have since forced the hand of political decision-makers and deprived them of any leeway to correct their course.
So, as the GST Council holds its 47th meeting in Chandigarh tomorrow, its main agenda will include a review of the GST rate structure, with the aim of aligning rates with the so-called neutral rate in terms of income (RNR) of approximately 15% estimated before the launch of the tax. There are no immediate plans to extend the tax to large areas left out, as the Center and states would like to retain discretion over taxes on high-efficiency auto fuels and avoid any uncertainty on that front. A series of rate cuts – mainly from the top 28% – and the expansion of the exemption list have admittedly increased the gap between the RNR and the weighted average rate of GST (11, 8% now) by three percentage points.
The council is however likely to postpone a major overhaul of GST rates to a later date, which could include more rate hikes than cuts and a reduction in the number of slabs to 2 from the current 4, to a later date as the current high rate of inflation situation does not allow for large tax increases. State governments are demanding that the comfortable financial protection granted to them for five years be extended. Although only opposition-led states publicly request it, other states, held back for political reasons, would also want an extended compensation period, to be sure. Some states also oppose the tax itself and feel they would have been better off without it, although the facts do not support this position.
If the GST had produced the desired results, the council’s agenda would not have been rate hikes and increased income protection for states, but giving more tax breaks to consumers from a position of fiscal strength. As such, high tax rates are contrary to the concept of a pure value-added tax with a broad and near-full base, which the GST is supposed to be.
Countries that have successfully implemented GST/VAT systems have proven that broad tax bases and favorable rates result in greater momentum. The key to increasing revenue is not higher rates and the burden of more taxes on a narrow universe of products and services (transactions), but a broadening of the base that will reduce the cascade to the bare minimum.
GST systems similar to those of India in Japan, Austria, Canada, South Africa and New Zealand are marked for much lower rates. These countries experienced sudden increases in tax revenue after the introduction of the GST/VAT, which allowed them to gradually reduce the rates. Some like New Zealand have reduced rates even below the initially calculated RNR. In India, reasonable revenue growth was seen immediately after the launch of GST in July 2017. FY19 revenue increased 9% from the FY18 base, while VAT revenue in ‘State before fuel taxes grew by only 8.4% in FY17, on a very favorable basis.
First, the guaranteed revenues offered to the States (annual growth of 14% compared to the level of the 2016 financial year) far exceeded the historical trend. GST revenue increased at an average annual rate of 9.2% during F19-FY22. Compared to this, States’ VAT receipts, excluding fuel taxes, increased by only 0.7% during the 2014-2017 financial years. A total sum of Rs 61.87 trillion has been collected in GST revenue (including compensation) over the past five years, but states have still received Rs 8.2 trillion as compensation , including transfers of Rs 2.7 trillion raised by the Center as a loan.
The five-year revenue protection for states was intended to offset the loss of their autonomous revenue space (VAT). The states, of course, had agreed to an equal distribution of GST revenue earmarking rights with the Center, even though many fiscal policy experts had recommended a higher share for them. The task force led by Vijay Kelkar under the 13th Finance Committee, for example, had said that 58% of GST revenue should go to the states.
The current buoyancy in revenue is attributable to improved compliance and policies that have catalyzed the “formalization” of the economy such as the GST itself. Effective curbs against fake invoices, a system that allows credits to be disbursed only after tech-enabled invoices have been matched, and stronger audit trails have boosted revenue. Yet if states are looking for revenue growth similar to that of the past five years, when some high growth was guaranteed, they would be in for a shock. A revenue shortfall of at least Rs 1 trillion on a combined basis is what they could expect in FY23 itself. Revenue protection has, to some extent, hampered state tax effort.
In a recent decision, the Supreme Court reiterated that the Center and the states simultaneously have the power to legislate the GST within a cooperative federal structure. This has inflated the threat that revenue-hungry states will tend to stray from the consensus path largely followed by the TSG Board. Such divisive tendencies would further weaken the country’s indirect tax system.
GST 2.0 reforms must include the taxability of automotive fuels, land, and real estate, in addition to correcting other structural issues that impede the continued flow of input tax credits. This will help reduce the overall tax rate and trigger the factor market reforms needed to strengthen the productive capacity of the economy. The current global economic crisis and concerns about macroeconomic stability may be constraints, but the new round of indirect tax reforms cannot wait too long.
(With contributions from Prasanta Sahu)