GST is a Big Reform but Beware Its Implementation

After many false starts, political consensus seems to be building in favour of the constitutional amendments required to facilitate the Goods and Services Tax (GST), described by the finance minister as the biggest tax reform since independence. It is no doubt an important reform but to think of it as one silver bullet which will rescue the economy is also not warranted.  It may be instructive to  go into the pros and cons of the GST reform.

In recent weeks Prime Minister Narendra Modi has passionately positioned the GST as an important “pro-poor reform” which will help India’s poorer states like UP, Bihar and Orissa. This is the first time Modi has made such a strong personal pitch for the GST reform. Over the past two years it was mostly finance minister Arun Jaitley who campaigned for GST. Evidently there had been some self-doubts among the Sangh Parivar thinkers over the real benefits accruing from the GST which would replace a plethora of cascading taxes in the states and the Centre.  With Modi advocating for GST so strongly, it appears all constituents of the Parivar are on board now.

There is no doubt that a single tax replacing all forms of regressive local taxes at the state and central level will make India a truly common market and, at once, remove the huge inefficiencies one witnesses in the form of the long queues of truckers at the border between states. A fragmented market made it easier and cheaper for the southern states to import certain agri-commodities from East Asian countries by sea rather than get it from India’s northern states by road which would amount to  crossing several borders, requiring payment of various local taxes at each stage. A plethora of state level taxes added to the costs of local manufactures, making them uncompetitive in the export market.

Now GST will subsume all these taxes in a single rate which will be refunded to exporters, making them more competitive globally. Because of these efficiencies, it is estimated that GDP growth will increase by up to 2 percentage points, that the inflation rate will go down as overall tax rate declines and that  government revenues will increase as large parts of the black economy become incentivised to become part of a simplified GST value chain. For instance a single GST will make it very difficult for a non-GST paying or black money generating business entity to supply a component to a GST-paying business as the value chain is transparently captured by the back bone IT infrastructure.

Trial by fire

So theoretically there is no doubt that GST vastly increases transparency and minimises rent seeking by the mammoth indirect tax bureaucracy at the Centre and States. However, the real test of GST lies in the way it is implemented. There is enough evidence collated by global economic research bodies which suggests that countries which implemented a somewhat flawed GST ended with little or no benefit in terms of higher economic growth and lower inflation. In fact the inflation rate went up in the medium term as a lot of new services and goods, hitherto untaxed, began to be taxed, thus hurting the consumers.

In India’s case, for instance, just imagine if a standard GST rate of 18% is imposed on all manner of services such as education, health, construction contracts, restaurants and a host of online services to consumers, the cost of living would go up as services form a strong component of the Consumer Price Index.  Besides, India is a hub for smaller business to business online software service providers. They will all come under the new GST tax regime, increasing the cost of business in the service sector. However, it may lower the costs in the manufacturing sector where existing taxes are already very high. So there will be winners and losers and theoretically winners should outstrip losers. However, if not implemented properly there could be more losers than winners. This would be disastrous.

One visible flaw in the current GST framework is that two major revenue generating sectors are kept out of the tax net – liquor and petroleum. Petroleum sector generates over 40% of the current indirect taxes at the Centre and states. Liquor is also a major source of excise revenues for the states. Incidentally, the liquor industry is also a major source of generating black money as a lot of it is sold without payment of excise duties.

Both these sectors are kept out to give the politicians flexibility in generating higher tax revenues when needed by increasing oil taxes and to avail of black money for elections by enabling sale of liquor outside the excise net. The late Ponty Chadda had enjoyed a monopoly of liquor vends in UP because he generated cash for major political entities.

These compromises could lead to a flawed GST. It would also not be pro-poor as Modi likes to describe it. For instance, just imagine if a GST were in place today with petrol and diesel prices as high as they are – nearly twice the price paid by consumers in Bangladesh or Pakistan. How is it pro-poor if a rich man driving an SUV in South Mumbai or South Delhi pays the same price for diesel as a poor farmer in Bihar or Orissa. A high indirect tax is inherently regressive as it charges the poor the same rate as it does the rich.  A low GST rate can still be justified on the ground that it is more affordable for the poor. But keeping such a huge sector, as petroleum , out of GST and treating it as a cash cow to generate revenues hurts the poor the most. Ask any of the millions of taxi drivers from UP and Bihar eking out a living in Mumbai, Delhi and Kolkatta as to how high petrol and diesel prices are hurting their incomes and you will know exactly what I am talking about.

So a flawed GST can be politically counter-productive. Many economists who favour the GST also admit there is a political risk involved in which technocrats are unable to come up with solid predictions; as many countries which have implemented some form of GST got  mixed results with several macroeconomic variables such inflation going up in the initial years.

The government’s Chief Economic Adviser Arvind Subramanian and Revenue Secretary Hasmukh Adhia have jointly written an article on the GST in The Hindu where they admit no country in recent history has really implemented the perfect GST. So the initial framework may  necessarily have flaws and each economy refines it as per its own experience. Subramanian and Adhia authors also write how some countries take years to refine their GST model. This is an honest admission that the GST we are implementing could be flawed and major correctives may have to be taken in future. It would, therefore, be a mistake to treat GST as a panacea for all the ills confronting our economy.