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India Needs to Get Its New Tax Right
May, 07th 2015

India’s long-awaited move to a genuine single market took a gigantic step forward on Wednesday when the lower house of Parliament passed a constitutional amendment that would make possible the introduction of a nationwide goods-and-services tax (GST) from April 2016. A single GST would replace the confusing plethora of taxes currently levied by central government in New Delhi and India's 29 states: excise duties, value-added taxes, even the odorous octroi -- a tax paid by truckers when crossing state borders. All this red tape is stifling -- a big part of the reason why some 60 percent of India's long-haul carriers are parked at any one time -- and often results in double taxation, resulting in onerously high indirect tax rates. Several experts suggest a well-designed GST would add as much as 2 percent annually to India’s GDP growth rate.

This being India, of course, there are reasons to be cautious. The government still needs to get the enabling legislation through the upper house of Parliament, which is dominated by the opposition Congress Party. Although Congress previously suggested it would support a GST, it's been emboldened by recent political victories and is now threatening to delay the bill for further examination and negotiation. Even if it passes, more than half of India’s states will have to ratify the legislation; only 11 of them are run by Prime Minister Narendra Modi's Bharatiya Janata Party.

Ironically, though, the biggest threat to a successful GST may be Modi's government itself. What matters more than passing the GST is implementing it properly. And that depends on two things: the rate at which it's set and the number of goods and services exempted from its purview. For best results, the tax needs to be reasonably low. That means it must also apply as widely as possible so that states -- who currently depend on indirect taxes for 80 percent of their revenue -- won't be starved of funds.

Early signs aren't encouraging. A provision in the current GST bill would allow states to levy an additional 1 percent tax on goods transported across state borders. Ostensibly, this is meant to appease heavily industrial states that produce the bulk of Indian goods but will no longer be able to tax them at the factory gate. In effect, it would simply replicate the octroi and prevent a true single market.

A government panel has suggested that in order for the central and state governments not to lose revenue, the tax rate will need to be set at 27 percent. That's absurdly high and would offer little relief from the current regime of cascading and overlapping taxes.

Finance Minister Arun Jaitley has admitted as much, saying he expects the rate to come down. The question is by how much. While Jaitley hasn't provided a figure, the Finance Commission, which decides the allocation of finances between the central government and the states, has suggested something around 14-16 percent.

That would be more reasonable. Unfortunately, the government’s decision to exempt alcohol, petroleum products and tobacco from the GST (as a sop to disagreeable states) may make it impossible to reach. Goods in these three categories account for around a third of all indirect tax revenues.

The exemptions are problematic for another reason. Modi hopes he'll eventually be able to persuade state governments to include these goods in the GST. It's probably more likely that such exemptions will set the stage for rent-seeking and lobbying to exempt other items, too. India’s past record suggests it's difficult to take away special exemptions once granted: The country's convoluted direct tax regime -- which has resulted in only 3 percent of the population paying income tax and companies effectively paying some 7 percentage points less than the official corporate rate -- is evidence of that.

Modi needs to get the GST passed in order to cement his reformist credentials. India needs a single tax to help cut down on waste, inefficiency and corruption. But in shepherding the bill through a difficult political process, Modi must be careful not to compromise on the two key principles of a low rate and as few exemptions as possible. Otherwise, India will end up with a system as complex and self-defeating as the one it's trying to replace.

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