Alternative framework needed to break political impasse on GST
September, 19th 2011
The open letters by chief ministers Jayalalithaa and Shivraj Singh Chouhan to the Prime Minister once again emphasise the formidable challenge of building a consensus between the Centre and the states on the Constitutional (Amendment) Bill for the Goods and Services Tax (GST). Even if the governments do reach an agreement, it is not a framework that would bring cheer to industry or serve the needs of the Indian economy in the 21st century. What is needed is an alternative framework, which is politically appealing and economically attractive.
The framework suggested by the Centre makes it mandatory for all the states to adopt GST, with full harmonisation of tax rates, tax base and laws. The states have serious concerns about the loss of their fiscal autonomy under this model and have made various demands to maintain their fiscal powers.
Industry is gravely concerned as the compromises being made by the Centre in the basic GST design to appease the states would dilute the benefits of GST and continue the inefficiencies that plague the current system. For instance, the proposed framework excludes certain sectors (petroleum, natural gas, alcohol and real estate) from the scope of GST. It envisages continuation of state taxes such as the local entry tax, local entertainment tax, and electricity duty. It is a design which would cost the industry dearly on account of tax cascading and would severely impact investments. The industry welcomes harmonisation, but not to the flawed base of the tax.
Thus, the fundamental issue is striking a balance between fiscal autonomy and harmonisation.
The recent tour of the Empowered Committee to Europe would have provided an opportunity to the members on how this balance is struck in the European Union (EU). However, the EU model may not be best suited for India. Instead, India should consider the Canadian model, which adopts a different approach for implementing GST.
The EU model has three important features. First, it makes the adoption of VAT mandatory for all member-states. Second ,it requires the VAT laws of individual member-states to be fully harmonised with the EU VAT directive, which can be modified only by the consensus of all members. The directive allows flexibility to the member states in setting the tax rates, so long as they are that or above the prescribed floor rates. Third, it allows member-states to continue certain deviating provisions through the system of derogations.
Interestingly, the proposed constitutional framework for India is founded on the same principles. It mandates replacement of the existing Centre and state sales taxes by a fully harmonised GST, which can be amended only by the consensus of all, and allows the states to continue certain local taxes.
While the EU model constituted a significant rationalisation of the then indirect tax regime in Europe, it has failed to keep up with the needs of the rapidly changing economies and is now saddled with many compromises and inefficiencies. For instance, the model provides exemptions for most financial services and supplies by public bodies, which are increasingly being taxed under modern VATs. They give rise to numerous complexities, but are now difficult to withdraw under the rule of unanimity for a change.
By contrast, in Canada, the Constitution empowers the federal and provincial governments to levy GST, without making its adoption and harmonisation mandatory. The federal government exercised these powers to levy a federal GST in 1991, and invited the provinces to replace their sales taxes by a provincial GST. Recognising the merits of harmonisation, the provinces elected to levy the GST and surrender their autonomy under bilateral agreements with the central government.
The elective Canadian model has produced a much better GST than the mandatory, unanimity-based EU model. The base for the Canadian GST is much broader, and harmonisation much greater among the participating provinces. It has the limitation of provincial GST not applying in the non-participating provinces.
India could follow the Canadian example. The Constitution could be amended to empower both the Centre and states to levy GST on all goods and services without any exceptions (i.e., including real property, alcohol, and petroleum). The Centre would be empowered to levy GST without any conditions. However, the states would be empowered to levy the GST only pursuant to a harmonisation agreement with the Centre. If they choose not to levy the GST, they could continue with their VAT and other taxes.
The requirement of harmonisation would be within the Constitution, but its detailed specification would be in the harmonisation agreement outside the Constitution. Nor would the mechanism for entering into, and enforcement of, the agreement be within the Constitution. If a state wishes to deviate from the harmonisation agreement, its taxation powers would be limited to those under status quo.
A potential drawback of this model is that it would be a partial GST, pending participation of all of the states. However, as in the case of introduction of state VAT, one hopes the model will be eventually adopted by all states. Regardless, half a loaf would be better than an indigestible full loaf.