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GST should be a good and simple tax
May, 20th 2015

The passage of the Constitution Bill by the Lok Sabha for the introduction of the Goods and Services Tax (GST) is undoubtedly one of the most significant achievements of the Modi government during the first year of its mandate.

The GST is a humongous reform that will alter the very face of fiscal federalism in India. It brings about a fundamental shift in the allocation of taxation powers between the Centre and the states. It repeals the powers to levy excise duties, service tax, and sales and purchase taxes, currently assigned to the Centre or states on mutually exclusive basis (a legacy of the British Raj), and replaces them by the concurrent powers to levy the dual GST. More fundamentally, neither the Centre nor the states can exercise the new powers unilaterally, but only through a collective body, the GST Council, almost akin to a 'super' government. It will design the tax, guided by the need for a harmonised tax structure and for the development of a common market. Collective design (and administration) of the tax will mean an end to ad hoc and whimsical policymaking and non-transparent tax administration. Thus, the GST ushers in the new era of co-operative federalism, which is critical for its success. Unless the Centre and states tango, the tangles between them can become a nightmare.

The model adopted by India is unique, without any precedence in the world. It is no surprise that the governments took so long to reach a consensus on the new constitutional framework. The clearing of the Bill in the Lok Sabha is an achievement that was made possible by the prime minister's statesmanship in dealing with the states, overcoming their mistrust and assuring them that their interests will be protected.

Finance Minister Arun Jaitley is disappointed at the Opposition's insistence in the Rajya Sabha to refer the Bill to a select committee. However, the slight delay on account of this referral should be welcomed. First, it allows the government the much-needed extra time for GST preparations. Both policy and process designs are way behind schedule and cannot be completed in an orderly manner prior to April 2016. Second, the referral to the committee provides an opportunity for ironing out certain kinks in the GST design and transforming it into a truly 'good and simple tax'.

The tax will be 'good' if it allows the markets to function efficiently (without the distortions caused by tax cascading), and the economy to prosper. The tax will be 'simple' if it applies in a neutral/uniform manner to all goods and services, regardless of whether they are produced locally or elsewhere. It must also be backed by simple forms and procedures and a robust IT platform.

The GST envisaged in the Constitution Bill falls short of these virtues. The Bill delegates the design of the GST to the GST Council, but imposes significant constraints on the choices it can make, which could deprive the tax of both goodness and simplicity.

The first constraint is the imposition of 1 per cent additional tax on inter-state supplies of goods, which is assigned to the origin state. The tax will apply every time goods move from one state to another, including inter-branch transfers of the same dealer. Multiple application of tax, with no setoff against the GST, will cause its burden to cascade as goods move through the supply chain. The tax will not apply to imports, and will dampen the prime minister's efforts to promote 'Make in India'.

Jaitley recognises the retrograde nature of this tax and has assured Parliament to make it non-cascading. However, there is no clarity how this could be done. The simplest way of making it non-cascading is to purge it altogether from the Constitution Bill. He should thus embrace with open arms any such recommendation from the select committee.

The second constraint is the exclusion of petroleum, alcohol, electricity and real property from the scope of tax. Exclusion would mean that no setoff would be allowed for the GST charged on machinery and equipment, raw materials, and parts acquired for use in production and distribution in the excluded sectors, resulting in loss in investment and productivity. These are important sectors of the economy and their exclusion will completely negate the 1-2 per cent boost in GDP that a good and simple tax could provide. The negative impact of the exclusions would be felt in: oil and gas exploration, development, refining, and distribution; construction of factories, office towers, hotels, breweries and distilleries, infrastructure, roads, bridges and tunnels, mobile towers, and other civil structures; and electricity generation (include solar and wind generation equipment), transmission and distribution. Even the farm sector and sugar mills supplying ethanol for alcohol, and blending with motor fuel could be adversely impacted.

A good and simple GST should ideally be imposed on all sectors. In any case, the choice to exclude any sector or specific goods or services should rest with the GST Council. The select committee should re-examine the Constitution Bill to ensure that the Council's options are not constrained to sub-optimal outcomes. The Bill should empower the governments to levy a good and simple tax, leaving the specifics of its design to the GST Council.

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