The GST Is Essentially a Modified Value-Added Tax At This Point

The Centre has recently proposed a four slab structure for the goods and services tax (GST). This would be 6%, 12%, 18% and 26% respectively and a cess beyond 26% for sin and luxury goods. The state governments have broadly supported the cess though there is disagreement over the slab rates. These rates will be discussed at the next meeting of the GST Council on November 3-4.

The upcoming meeting is, therefore, crucial and several of the issues involved require further scrutiny. There are several inflationary dangers involved and if care is not taken, far from becoming a panacea for economic growth, the GST could end up being an unmitigated disaster.

Generalised inflation and stagflation

Indirect taxes are levied on consumption while direct taxes are levied on income. Increasing the former makes consumption more expensive and thus has an inflationary effect, which hurts the poor the most. It is for this reason that indirect taxes are generally seen as regressive. For the same reason, direct taxes, which are targeted at the rich, are seen as progressive.

The GST as an indirect tax has significant potential for inflation. To begin with, the vaunted benefit of eliminating the cascading effect is unlikely to happen, though it may be reduced. This is because of the large list of exemptions, which at present is proposed to cover 300 items in the Centre and 80 items in the states, meaning half of all goods and services. The second reason is the lack of input tax credit between the central, state and integrated GST. Thus the continuance of the cascading effect will contribute to inflationary pressures.

This is exacerbated by the recent proposal for a four-slab structure and introduction of the cess. The cess will directly drive up prices, although the Centre’s justification is that it is necessary to compensate the states and will only be levied on luxury and sin goods (cigarettes and the like). The state governments, truly worried about their loss of revenue, have agreed to this proposal which is expected to raise Rs 50,000 crore. The vice chairman of NITI Aayog, Arvind Panagariya, has sought to downplay anxieties by stating that the cess can be withdrawn ‘at any time’.

The four-slab structure essentially taxes basic goods (such as food and healthcare) less and high-end goods (cars and refrigerators) more. Though this ostensibly seems progressive, it has been criticised by former finance minister P Chidambaram as ‘disastrous’ and even 13th finance commission chairman Vijay Kelkar has stated that it will lead to a 75% reduction in the benefits originally envisaged.

There are several reasons for this criticism: the first is that slabs mean a classification of goods and services into various categories, which drives up administrative cost and complexity. Second, it lends itself vulnerable to classification disputes, such as the infamous case of the Supreme Court having to decide whether coconut is a fruit or a nut. Third, it encourages evasion and lobbying for frequent rate changes, which is easier to do for a specific slab rate but much harder to do for an overall rate. In addition to these problems, the 13th Finance Commission also raised the issue of slabs driving up the ‘average’ tax rate and thus leading to generalised inflation. By contrast, a single rate is easier to comply with, harder to lobby against and eliminates the problem of classification disputes. Thus the present four slab structure has been rightly been called out by Chidambaram as a modified version of the existing value-added tax (VAT), with its accompanying problems of cascading effect and classification largely intact.

It is also worth noting the 13th Finance Commission’s recommendations on the GST: it had called for a single positive rate of 5% Central GST (CGST) and 7% State GST (SGST). Kelkar had hoped that the rate would be at most 12%. Such low rates would have benefited both industry and consumers, but the present proposal is a long way from this.

Additionally, the very structure of the GST will mean that there will be a higher tax rate on the initial stages of production and a lower rate on the later stages. Thus, prices of basic and intermediary goods will likely rise, contributing to generalised inflation. For example, a rise in diesel prices makes transportation more expensive, driving up overall prices.

Given these issues, there is a real danger that the GST in its present form may even end up contributing to stagflation, a situation where production slows due to lack of demand, which in turn reduces due to high prices.

Increased pressure on small and medium enterprises

Another danger is the potentially debilitating effect the GST may have on small businesses, which form the majority of the economy. The GST, as it is right now, is essentially a modified version of the value-added Tax (VAT) and shares many of its features. Prior to the introduction of VAT, small scale industries were exempted from indirect taxes. This was resented by big businesses and multinational corporations (MNCs) who pushed hard for the implementation of VAT, as it would, inter alia, include the small scale industries. The tax was finally introduced in 1986 as modified VAT (MODVAT) and its scope was gradually expanded to include more and more goods.

The New Economic Policy (NEP) of 1991 accelerated this process. The World Bank demanded that VAT be implemented in the country as part of its conditionalities for its structural adjustment loan during the balance of payments crisis of 1991. This was in keeping with the market fundamentalist ideology of the Bretton Woods institutions (World Bank and IMF), which seeks to reduce taxes on the rich and increase taxes on everyone else. This is to be done by reducing tax on trade (sales tax) and reducing income and corporate taxes, while at the same time increasing indirect taxes such as VAT.

This is the agenda underlying the phrase ‘broaden the tax base’ and is the same reasoning which argues for the GST. Thus it is no surprise that the only sustained support for it has come from big businesses and MNCs. Compared to MSMEs, these stand to benefit more if taxes on sales and manufacturing (excise) are removed altogether as they possess economies of scale. Further, the compliance burden of GST, while an improvement over the plethora of taxes that it subsumes, is by no means easy and will disproportionately affect MSMEs.

This is worsened by the fact that the administrative infrastructure necessary to collect the GST has a long way to go. The GST Network (GSTN), a non-profit organisation tasked with setting up the necessary IT infrastructure, has already become enmeshed in controversy. Coming to the taxpayers, it will take time to set up the necessary compliance systems and given the vast size of the Indian economy, this could take quite a while. The net result can be a chaotic situation which renders MSMEs vulnerable to high compliance costs and administrative harassment.

This has already happened in Malaysia, which introduced GST in April 2015 amidst widespread opposition. The tax has subsequently drawn street protests and has been blamed for rising living costs and compliance confusion for businesses. As the Indian economy is far more complex than Malaysia’s, with considerably lower levels of government efficiency, a far worse scenario may take place.

Impact on panchayats and municipalities

One aspect of the GST that has not been discussed enough is its impact on the finances of local governments. Presently across the country, with a few exceptions, local governments such as panchayats and municipalities have poor resource mobilisation capacities. Though the Constitution grants them certain tax powers under articles 243H and 243X respectively, these are barely utilised. Alternative options such as municipal bonds are almost unheard of. The chief source of their sustenance is funds devolved by state governments. This is a miserly relationship, similar to the one between the Centre and states, and most local bodies are starved for funds.

This financial situation is responsible in a large way for the poor condition of Indian cities and villages. The reduction in state finances will likely have a detrimental impact on local body finances and may further worsen this state of affairs.

Direct Taxes Code and GAAR as necessary complements to GST

In the last GST Council meeting held on October 19th, the option of raising direct taxes to compensate the states was discussed. It is unfortunate that this was not considered, and the regressive alternative of a cess chosen instead. Raising revenue through direct taxes would spare the common people, especially the poor, from the burden of inflation and would only affect the rich. It can also save the local bodies from the dangers of reduced state finances. Additionally, the fiscal deficit, something the present government is deeply concerned about, can be kept in check through funds raised from direct taxes. By contrast, a cess will affect all, not only the rich, and contribute to inflation. This is bound to have a negative political impact which will display itself in time.

The government’s hesitation to increase direct taxes – though they would only affect the rich – is understandable. However, there is a way around this problem. First, it must be clear which tax is to be increased – income or corporation tax? Tax officials fear that increasing corporation tax will have an inflationary effect as the burden will be passed on to the consumer. This is not necessarily the case as companies have to maintain market competitiveness and cannot always automatically increase prices. However for the sake of expediency this argument can be accepted. On the other hand, no such claim can be made with regard to increasing income tax, which is what the focus must be on.

At present, 99% of Indians do not pay income tax. Thus it is pointless to discuss increasing direct taxes when the capacity to execute is so limited. The focus must be on strengthening tax administration by filling up vacancies, ensuring use of the latest technology and most importantly giving political backing to tax officials. The appellate tribunal in the Central Board of Direct Taxes is an institution that especially needs reform, as it frequently exonerates those accused of tax evasion. This can be done silently, without raising much opposition from vested interests and only requires political will.

At present, the 1% who do pay income tax provide revenue of Rs 2.86 lakh crore to the government, which is quite substantial. Increasing the efficacy of tax collection is thus bound to yield the Rs 50,000 crore that is necessary to compensate the states and will also be politically expedient.

However, this by itself is not enough. In the long run, the government must introduce reforms to the existing system of direct taxes. Two long-pending legislations – the Direct Taxes Code and the General Anti Avoidance Rules (GAAR) – must be removed from the cold storage where they are presently languishing and implemented on a war footing as the next major tax reform. GAAR, in particular, is a major requirement in the fight against tax evasion and assumes renewed significance in light of the slew of Double Tax Avoidance Agreements that are being revisited. It is early notification will significantly aid the government’s ongoing efforts in cracking down on illicit cross-border financial flows.

Thus it is clear that direct tax reform is crucial to counter the negative effects that the GST can have. On a final note, the GST debate also raises questions on the nature of tax policy: is tax solely meant to facilitate ‘ease of doing business’? Or is it also a means of redistribution and social justice, through which a level playing field can be created and inequality reduced? To see it solely as the former is to see only half the picture, and as inequality increases both in India and globally, the relevance of tax as a tool for social justice becomes more and more apparent.