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On GST states too have a point
October, 28th 2010

At a seminar on a free trade agreement with Asean, someone rightly said that India needs an FTA with itself first and then it should start looking out. One of the main hurdles to free trade between and among states in India is the state border checkposts to collect sales tax, as the rates vary. In its wisdom and following the recommendations of the Kelkar task force, the government decided to bring in a goods and service tax (GST) that will be uniform, doing away with the prevailing distortions.

To usher in the GST, the government established an empowered committee of state finance ministers under the leadership of West Bengal minister Ashim Dasgupta , thus neutralising one possible opposition. This committee will meet later this week to try and clear the final hurdle for adopting the GST. This new regime, when implemented, is expected to increase the country's GDP by $500 billion and exports by up to 15%.

As we know, the fiscal health of an economy depends on the tax regime that it follows. It is universally accepted that fiscal health is positively linked to the shares of direct tax revenue in total tax revenue and GDP. However, these shares were not satisfactorily large during the 1960s and 1970s. The first major attempt to reform the Indian tax regime was made in 1986 through the longterm fiscal policy. These and subsequent changes have resulted in some significant gains - for instance, the share of direct taxes as a percentage of the total tax revenue has increased from 43% in 2004-05 to 58% in 2009-10 . Though the share of indirect taxes has fallen significantly, this was because of the faster growth in direct tax collections, rather than any slackening in the growth of indirect tax collections. Thus, further simplification of the indirect tax system is called for.

The introduction of the GST to replace the existing value added tax (VAT) constitutes the next logical step in this course of action - the last mile in the first stage of reforms - as it seeks to integrate the Indian economy without undermining its federal structure. Estimates show that the proposed GST regime will be revenue-neutral and states will be compensated in case of any revenue loss.

A two-rate structure will be proposed - a lower rate for essential items and goods of basic importance and a standard rate for goods in general (along with a special rate for precious metals and a list of exempted items). Exports would be zero-rated and the GST will be levied on imports. There will be a uniform state GST threshold of. 10 lakh for both goods and services with compensation for states (particularly north-eastern and special category states) in contrast to the lower threshold in the VAT regime.

Some states are opposing the introduction of this modern regime. Much of their opposition is on the ground that their financial autonomy will be eroded. This is more political than economic. The Centre-state financial relation has come a long way since the heydays of the 1980s. Successive finance commissions have done a commendable job to uphold the federal structure of our economy. Coalition politics at the Centre and states have also played a major part in stabilising this relation. The dispute settlement mechanism that will accompany the GST will not only strengthen this structure but also provide the much-needed stability to the overall tax structure and administration system.

In a federal country like India, the most important feature of an indirect tax regime is that there should be a dual regime in place. In many federal countries like Brazil and Canada, the dual system is successful in making those economies more integrated and competitive. The Canadian model of harmonised sales tax combines the GST and provincial sales tax into a single tax with features such as tax rebates to low-income consumers.

Over time, the Indian GST regime should be reformed further to move toward a system like that in Canada so as to avoid the cascading effects of the current indirect tax regime, simplify tax compliance and widen the indirect tax base. However, it is important to note that there is a strong economic reason on the part of some states to oppose the proposed GST regime.

Computations reveal that proposed GST rates would lead to decline in revenues for state governments and such decline would not merely be transitional in nature but continue until certain structural deficiencies in their economies are corrected. While the Centre has agreed to compensate states for any revenue loss on account of the proposed GST regime, they should be allowed to have more flexibility to raise their revenue and also assisted to overcome structural deficiencies in their economies.

Otherwise, we could see a return to the uncertainties in Centrestate financial relations experienced in the 1980s. This would surely undermine the much-needed political buy-in necessary for smoothening the process of second generation reforms and to create a barrier-free market in India.

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