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Simple rules for a complex world: GST classification
June, 12th 2018

A difficult reform across different levels of the federal system is rarely easy, but perhaps the least difficult in this moment before the next election

As we approach the first anniversary of the goods and services tax (GST) reform, it is a good time to take stock of the problems in the system. Introducing GST in India was no small feat, but it has become increasingly clear that the system is too complicated and has led to a lot of confusion for taxpayers.

India has five different GST rates—0, 5%, 12%, 18%, and 28%. According to the World Bank India Development Update 2018, of the 115 countries with GST regime, 40 countries use a single rate and 28 countries use two rates. India keeps rather poor company with Italy, Ghana, Pakistan, and Luxemburg—countries with four or more rates.

India does worse still, because in addition to these five tax rates, there are some exceptions. Some goods are categorized as luxury and sin goods, deserving a special cess in addition to the GST rate. There are some special goods taxed at low rates like gold (3%) and precious gemstones (0.25%).

One might think five different rates is not so bad, once there is a clear code of classifications, and people get enough time to get used to the new system. After all, the government did a remarkable job of producing a detailed list of classifications in the Harmonised System of Nomenclature (HSN)—an eight-digit code for goods classification—which tries to provide and stipulate a code for every conceivable product category. One year into the GST regime, the HSN code-book for GST classification contains 18,306 entries in 438 pages.

Even after doing such a detailed job, there is confusion. What happens when a good or service could fit in two different categories, taxed at two different rates? For instance, should Pepsi’s Nimbooz be classified lemonade (taxed at 28%) or as pulp juice (taxed at 12%)? Most firms provide a canteen, but most firms also have the food prepared outside the premises, often by a third party. Should they be taxed at 5% or 18%, because canteen service is taxed at 5%, while outdoor catering is taxed at 18%. A few months ago, members of the industry reached out to the finance ministry and the GST council to clarify the matter.

The opposite problem also exists, where variations of a good are taxed under different rates. Last year there was a sweets dispute. Plain barfis were taxed at 5%, but barfis with dry fruits could be taxed at 12%, and chocolate barfis at 28%. The GST council had to clarify that chocolate barfis would be taxed at 5% as barfis and not as chocolate.

If one goes to the GST council website, there are a few hundred notifications, more than one for each day in existence. And that is just the Central government notifications. Each state has its own set of notifications. There is a constant process of raising disputes and questions, and the government trying to clarify classifications and solve problems. Then there are the legal challenges in courts. And this is only about the current stock of goods and services. It does not account for new products and services that will enter the market in the future.

Some blame the government for not doing a good enough job of detailing and specifying various classifications. Actually, it has done a remarkable job, but that is hardly the point. The problem is that it is an impossible task. No matter how detailed the classification code-book, there will be disputes and confusion, because we live in a world with interesting, complicated and customized goods and services with many dimensions and serving many needs.

The finance ministry and the GST council are asking the wrong question. The point is not how best to classify each good, but to realize the impossibility of successfully classifying each good. Therefore it is best to do away with the need to classify each good. A single GST for all goods and services needs no classification system. Every individual and firm simply pays the same rate, and the government and the legal system can use valuable time and resources resolving other problems.

As the world around us grows in complexity, there is a tendency for governments to think we need more detailed rules and systems to regulate the dynamic nature of our economy and society. Counter-intuitively, the greater the complexity, the more we need simple rules to guide us through the maze of choices.

The title is borrowed from the book by Richard Epstein, one of the best-known legal theorists in the world. His idea is that the simplicity of the rule will better help individuals and firms deal with many choices and the changing condition of the world around us. A complex tax system, on the other hand, adds burden to the human ability to navigate the numerous choices in a dynamic world.

The greater the number of goods and services in the economy, the better it is to have fewer classifications and rates. In fact, a single rate does the job quite well. If the government can simplify the GST rates to a single rate and do away with the need for classification, it would reduce uncertainty, resources spent on resolving disputes, and compliance costs. However, the GST council needs to agree to a single rate.

In a unique moment in India, 21 states, with almost 70% of the population, are currently governed by the Bharatiya Janata Party (BJP). A difficult reform across different levels of the federal system is rarely easy, but perhaps the least difficult in this moment before the next election. If anyone can accomplish this, it is Prime Minister Narendra Modi.

Shruti Rajagopalan is an assistant professor of economics at Purchase College, State University of New York, and a fellow at the Classical Liberal Institute, New York University School of Law.

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