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Cap on GST rate means limiting governments powers to levy inordinately high indirect taxes
July, 27th 2016

A Google search on how not to pay taxes in India yields 12 crore (120 million) results,” remarked Prime Minister Narendra Modi sardonically, at a conference of tax administrators in April. “Double the tax base and collect taxes from 10 crore (100 million) people,” he exhorted the tax officials. The implicit message is that in the land of a billion people, only a handful of 50 million pay taxes. Conversely, it is also true that almost every Indian pays taxes.

This is the great Indian tax paradox: very few pay taxes but also everyone, rich or poor, pays high taxes. This is because of India’s lopsided direct tax (income and wealth) versus indirect tax (goods and services) structure, where only a small minority pays income tax and, to compensate, almost everyone pays high goods and services tax.

Direct taxes are fair and progressive since they are proportional to your income or affordability. Indirect taxes are regressive because you pay the same amount, irrespective of your income or wealth level. It is a simple rule of basic tax theory that a majority of tax collection should be through direct taxes. Indeed, this is the norm for most developed countries. India is exactly the obverse, collecting nearly two-third of its taxes through regressive indirect taxes.

Past governments have always resorted to increasing rates of indirect taxes, rather than expand the net of direct tax payers. The addition of the Swachh Bharat and Krishi Kalyan cesses and increase in excise duty on petrol are examples of recent indirect taxes. So, Modi is right in asking for a doubling of the tax base for direct taxes. It is also equally important that the easy backdoor to tax collection through covert increases in indirect tax rates is firmly shut. This is what a cap on the proposed goods and services tax (GST) can achieve.

In 1991, Raja Chelliah was appointed to chair a committee on tax reforms. India’s overall tax-to-GDP ratio was 16% then. About 85% of these tax revenues of the Centre and states combined came from indirect taxes and 15% from direct taxes. Chelliah submitted his report in 1993 that urged the Indian state to collect more taxes through direct taxes. Aquarter century on, India’s indirect-to-direct tax ratio is 65:35, down from the 85:15 ratio in 1991, but still a far cry from the average 35:65 ratio of most other countries.

India has the dubious distinction of having one of the lowest direct tax-to-GDP ratios in the world. The GST legislation presents a golden opportunity to fulfil Chelliah’s dreams.
In 1991, the peak income-tax rate was 50%. It has been consistently reduced to 30% today. But the number of income tax payers has grown only marginally. In contrast, service tax in 1994 was 5%. It has been increased over the last 25 years to 15% now. Excise duties on petrol that affect all equally have been increased nine times in the last year alone. A cap on the GST rate can put a stop to such indiscriminate indirect taxes that affect the poor much more than the rich.

Some commentators argue that India’s indirect tax structure is not regressive because a bulk of the goods and services that the poor consume are exempt from such taxes. So, icecreams and branded clothes in retail stores attract service tax, but roadside chaats and clothes don’t. Such paternalism to decide what the poor and rich should consume makes our tax structure even more regressive.

The very premise of a GST is to move to a cleaner, progressive and more efficient tax system. Levying taxes based on the government’s classification of luxury goods versus poor man’s goods is neither progressive nor efficient.

That the country’s tax structure is distorted and regressive is well accepted. That all governments in the country adopt lazy taxation policies by increasing indirect tax rates constantly is well documented. That it is time to end this unhealthy practice is well understood.

The GST Bill presents a landmark opportunity to do this by limiting the powers of governments to levy inordinately high indirect taxes. This can be done by incorporating a ceiling rate of GST in the GST Bill and not in the Constitution. Once such a ceiling is specified in the Bill, the GST rates can be changed at will by the GST Council through an executive notification process rather than through a Parliament process in adherence to that ceiling.
In the 25th year of the landmark 1991 economic reforms that helped lift hundreds of millions of Indians out of poverty, there is also a unique opportunity to correct past wrongs. One tax on all goods and services across the entire nation with no unfettered powers to raise tax rates seems like the distant Promised Land, far from the current maze of a regressive tax structure.

The good news is that a cap on the GST rate specified in the GST Bill will get us closer to that Promised Land.

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