The goods and services tax (GST) was a major reform that took years to implement. It is now six years old. The great promise of GST is tax collection buoyancy, thanks to inbuilt incentives of compliance, and less scope of leakage.
The goods and services tax (GST) was a major reform that took years to implement. It is now six years old. The great promise of GST is tax collection buoyancy, thanks to inbuilt incentives of compliance, and less scope of leakage. An important feature is that the tax burden is applicable only on the value-added in the economic chain. You first pay tax on the full value realized, but get credit on all taxes paid on inputs. Hence, you would rather deal with suppliers who can produce proof of having paid their share of taxes. These are the interlocking incentives between suppliers and customers in the entire chain that ensure greater compliance. GST, thus, eliminates the older inefficient structure of taxes paid on taxes. It also makes the tax burden fairer across the economy. It has removed inter-state barriers to commerce. A study commissioned by the 13th Finance Commission and conducted by the National Council of Applied Economic Research (NCAER) in 2009 estimated that the annual rate of growth in gross domestic product (GDP) would rise by 2-2.5 percentage points on a sustained basis because of GST. This was because the tax burden would get equitably distributed across the value chain, particularly between manufacturing and services. Reduced costs would increase profits, efficiency and productivity, and Indian exports were expected to go up by 10-14% year after year. Good news on all fronts, be it growth, the fisc or exports.
Has this promise been fulfilled? The answer, unfortunately, is an unambiguous 'no.' Buoyancy of indirect taxes has not gone up if you exclude the high contribution from imports. This is confirmed by the Economic Survey of 2023. The increase in our GDP growth rate is nowhere near what was anticipated by the NCAER report, even after discounting the effect of covid. Leakages in the tax system have not been plugged fully.
Growth in GST revenues should not only keep pace with nominal GDP but overtake it. But that is not the case. The chairman of the Prime Minister's Economic Advisory Council said this week that the government is losing revenue under the GST regime. He said the estimated average tax rate was designed to be 17%, but the actual and effective rate was only 11.4%. Several exemptions and rate cuts were made that have caused a drop in revenue collection. Thus, not only has the GST not led to buoyancy, but has in fact led to a lowering of tax revenues.
How did this happen? The main culprit is the proliferation in rate slabs. Many items are still stuck at the 28% rate or even higher. The reason we cannot reduce the higher rate and converge the rates to the median and lower rate of 17% or 18% is that there are numerous items with a zero or 3% rate. If you want to reduce the 28% rate, then you have to move items from the 3% rate to 12%. It is a tug of war between exempt and overtaxed items. This tussle plays out in the GST Council, with representation from all states, big and small. That 2009 NCAER report about buoyancy of tax revenues and sustained GDP growth was premised on a single rate, preferably closer to 15%. The earlier Vijay Kelkar committee on indirect tax reforms had stipulated an even lower rate of 12%. So, we have drifted far from the original design of a single rate.
The second major reason (apart from the multiplicity of rates) is the fallacious concept of a revenue neutral rate (RNR). This was the focus of all prior discussions and reports, and even the bargaining between the Centre and states as a prelude to the passing of the GST law in Parliament. It missed the point that the behaviour of tax compliance is very different between the pre- and post-GST regimes. Indeed, a lower rate with interlocking incentives for compliance would lead to greater revenue collection. That same rate, if used as a reference for pre-GST calculations, would imply lower collection, violating the principle of an RNR. But this idea itself is flawed. Remember the Laffer Curve? The RNR approach has done more damage, because it has caused the median rate to drift up. It also aggravates the inequity inherent in indirect taxes. The poor bear a greater relative burden of GST as a proportion of their incomes. And to undo that damage, the GST Council and public opinion favour an increase in the number of items attracting zero or 3% rates. This makes the situation worse in this never-ending tug of war.
A third reason for our GST hiccup is that along with rate multiplicity, we have a plethora of exemptions and arbitrary classifications, leading to disputes, litigation, clogged cases and pending refunds. This might get worse if we set up multiple appellate tribunals, one for each state. It will likely lead to an unending litigation nightmare.
A fourth reason is that large parts of the economy remain outside the ambit of GST. Their inclusion is necessary to bring the overall rate of taxation down.
The GST promise is only half fulfilled. Due to high rates and cost of compliance, it has hit small businesses particularly hard. Even if the small entrepreneur pays a composite rate of 6% with no recourse to input tax credit, it directly eats into his profits. He does not have the power to raise prices.
Thus, high rates must come down for everyone, including for imports. Tax compliance must be made simpler, with a free app (a la Bhim for UPI) developed by the government to ease the entry of small businesses into the GST net. It is true that GST is a remarkable reform and there's no going back. But much work is still needed to redeem its promise.