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M Govinda Rao: GST - Hiccups in the 'grand bargain'
June, 01st 2010

Enactment of the new Direct Taxes Code and implementation of GST are two most important reforms that are expected to significantly minimise economic distortions and reduce the compliance cost. As regards the former, the Ministry of Finance is revising the draft of the Code based on the comments received from various stakeholders and is expected to place it in the monsoon session of Parliament.

One can reasonably expect that the Code will come into force from April 2011 as scheduled. However, GST implementation has not proceeded smoothly and considering the enormity of the tasks that remain, it is unlikely to be implemented in April 2011.

The most important issue to be resolved in the introduction of GST is the finalisation of the structures of central and state GSTs, operational modalities, a mechanism for compensating losses, a machinery to ensure effective compliance by both the Centre and the states, a system to ensure seamless credit for the tax paid throughout the country, including electronic processing of inter-state transactions and changes in the administration.

The process is stuck as the structure of GST and operational modalities are yet to be finalised before other components of the reform are brought in. In fact, the report of the Thirteenth Finance Commission (TFC), rather than accelerating, has actually reversed the process and it will take some time before the threads are picked up again.

The problem with the Finance Commission was that it considered GST reform not as a process but an event in itself. It should be noted that it was the introduction of VAT in 2005-06 which was the game-changer and introduction of GST is only the next step in the process. While it is important and necessary to target the model GST, mandating it as a ground rule leaves very little room for the grand bargain.

Furthermore, stipulating a corner solution that if any state does not adhere to the design, operational modalities and binding agreements of the model GST, it will not receive the compensation has led the states to adopt a defiant posture. You cannot have a choice between the model GST and none at all in matters relating to the reform of consumption tax in the country involving both the Centre and the states.

The most contentious issue in the design is the revenue neutral rate estimated by the task force of the Commission. Surely, everyone would like to have the tax rate low, but it is important that the estimate should be realistic. To begin with, taking the average values of the base arrived at by employing five different methods defies logic and shows the lack of confidence by the task force in its own estimates.

In fact, one of the methods is the so-called Shome Index: which is not a method at all; it is broad generalisation that the revenue-GDP ratio from the tax would vary from a third to half of the nominal rate of tax and one should try to be close to half! Other methods used for estimation suffer from significant overestimation due to the assumption on unorganised sector purchases and the value of real estate transactions.

An NCAER study estimates the productivity gains to the economy and revenue neutral rate of GST using the 2003-04 input-output table. Given that the base table used was even prior to the adoption of VAT, it overestimates both productivity gains and the base of GST. As far as the Centre is concerned, at a time when it has to augment revenues to restart the fiscal consolidation process, it cannot risk losing revenues and providing compensation to the states.

In his otherwise erudite article, Satya Poddar (BS, May 25) asserts that successful models of GST feature single and low rate of tax and cites the examples of Japan, Singapore and New Zealand. Based on this, he argues that the GST rate for the Centre and the states in India need not be more than 10 per cent. He also states that in case the rate is inadequate, it could be increased later! While it is certainly desirable to have a low rate of tax, it is important to ensure that it does not result in loss of revenue. Similarly, while there is much to be said in favour of having a single rate, the decision to have one or two rates is guided by socio-political considerations and if most states feel comfortable having two rates, we will have to live with that.

Incidentally, the tax rate in New Zealand is 12.5 per cent (and not 10 per cent as stated by Poddar) and the Budget presented on May 20 proposes to increase it to 15 per cent from October 1, 2010. This is despite New Zealand having virtually no exemptions. As regards Singapore and Japan, they did not face the type of fiscal compulsions that India faces today.

One can also cite several successful cases of GST with high rates and the average GST/VAT rate in the European Union itself works out to 19.5 per cent, and the average for OECD countries works out to 17.7 per cent. The average tax rate in Latin American countries is 14.4 per cent and it is much lower at 10.8 per cent in the Asia-Pacific. The argument that if found inadequate we can increase the rate will not hold water; it is easier to bring the rate down than to increase it.

Fortunately, the action taken report on the TFC report presented by the Ministry of Finance to Parliament has only accepted the recommendations in principle and, therefore, there is room for grand bargain. By and large, it seems that the states are comfortable with the idea of having two rates a lower rate of 5 per cent on essential items and a general rate of 10 per cent on goods and services would perhaps be acceptable.

Agreement on the rates and compensation for any loss of revenue for a reasonable period of time could restart the reform process. Given the trade-off between fiscal autonomy and tax harmonisation, we should settle for what is feasible rather than throwing the baby with the bathwater.

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